Options for Europe – Part 56

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).


Chapter X The Stability and Growth Pact – neither growth nor stability


After all the haggling was done, the European Council meeting in Amsterdam on June 16-17, 1997 finally agreed on the form that the Stability and Growth Pact would take. It was held out as part of the strategy to “create favourable conditions for economic growth and new job opportunities” (European Council, 1997a). There were two European Council regulations added to the formal resolution.

First, the so-called ‘preventative arm’ – “on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies” (Council Regulation (EC) 1466/97, July 7, 1997) – relates to the country-specific medium-term budgetary objective (MTO), which involve each Member State submitting their fiscal plans in “stability and convergene programmes” on an annual basis to the European Commission. This regulation became operational on July 1, 1988.

Second, the so-called ‘corrective arm’ – “on speeding up and clarifying the implementation of the excessive deficit procedure” (Council Regulation (EC) 1467/97, July 7, 1997) – relates to the Excessive Deficit Procedure (EDP), which outlined a process whereby so-called “excessive deficits” will be eliminated. The 3 per cent and 60 per cent rule were central here with various other parameters that we have already discussed in place to define special circumstances. This regulation became operational on January 1, 1989.

In the official resolution it was asserted that (European Council, 1997b):

Adherence to the objective of sound budgetary positions close to balance or in surplus will allow all Member States to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3 % of GDP.

While the European Commission Italianer and Pisani-Ferry 1991 Regional Stabilization Properties of Fiscal Arrangements: What Lessons for the Community

No research had established the validity of that claim and there was plenty of evidence already available to refute it (for example, Eichengreen, ;

Eichengreen (1997: 92), a notable US critic of the EMU, juxtaposed the emphasis in the MacDougall Report (1977) on the need for a significant European-level fiscal function (of at least 5 per cent of total European GDP) to “offset asymmetric shocks once monetary independence is lost” with the Delors Report (1989), which considered establishing this capacity would be politically impossible. The Delors alternative, subsequently reflected in the Maastricht Treaty (1991) was to impose tight controls on the national fiscal positions in the blind hope that these constraints would allow the European Central Bank to maintain price stability, which in the Monetarist dogma would maximise real economic growth. All the so-called stabilisation functions would be done at the regional (Member State) level using the so-called ‘automatic stabilisers’ that are built into national government fiscal positions (or ‘budgets’).

[subheading]What are automatic stabilisers?[/subheading]

For any government, the fiscal balance is the difference between total revenue (mostly from taxes) and total outlays (or spending). If total revenue is greater than outlays, the fiscal position is in surplus and vice versa. You might think that if the fiscal deficit is increasing, then the government must be aiming to spend more than it is raising in revenue. However, what is not often understood, is that movements in the fiscal balance, over say a year, do not provide a reliable indication of the policy intent of the government.

A basic rule of macroeconomics is that total spending in the economy generates national income and output of an equal magnitude, which then drives employment growth. If spending increases then production of goods and services will increase and the suppliers of the inputs will receive extra income. This process continues until the economy cannot produce any more goods and services (a state we call full capacity or full employment) and if spending continues to increase after that, inflation will result, because firms will react to the pressure by putting prices up.

If the government spends less than it takes out of the economy via revenue (that is, records a fiscal surplus) – its net spending is negative – and this will reduce output and income (a ‘contractionary’ impact). Alternatively, if the government is running a deficit (spending more than its takes out of the economy in revenue) – – its net spending is positive – and this will increase output and income (an ‘expansionary’ impact).

However, without further information we are not in a position to know whether these positive or negative impacts on growth reflect the chosen policy position of government. The uncertainty arises because there are so-called ‘automatic stabilisers’ which operate as a result of swings in economic activity, which are, in part, influenced by the discretionary shifts in government fiscal policy.

The point is that the components of the fiscal balance are the outcome of discretionary policy choices made by the government (tax rates, government spending programs etc) and the state of the economy. When the economy is growing strongly and employment is high, tax revenue rises and welfare payments (unemployment benefits etc) fall. The opposite impact is observed when the economy moves into slower growth or even recession. These fiscal shifts that arise purely as a result of the state of the economy (for given government policy choices) are what economists call the ‘automatic stabilisers’.

As a result, assume that at some point the fiscal balance is zero (that is, government spending exactly equals its revenue). If the government maintains its fiscal policy settings but economy then moves into recession, the fiscal balance will move into deficit because tax revenue will fall as less people are employed and company sales fall. Welfare payments will also likely rise increasing the spending side of the fiscal position. Conversely, if from a starting balance of zero, the economy starts growing strongly, the fiscal position will move into surplus because tax revenue rises and welfare payments fall.

This simple example highlights that shifts in the reported fiscal balance can occur without any discretionary intent on behalf of the government. You could imagine a situation where the government was actually intending to slow the economy down by targetting a surplus but the state of the economy was weak that the loss of tax revenue and increased welfare payments pushed the fiscal balance into deficit.

The operation of automatic stabilisers thus attenuate the amplitude in the business cycle by expanding the fiscal deficit in a recession and contracting it in a boom. However, while they lessen the negative impacts of a recession they do not eliminate them and if the recession is severe enough then additional discretionary fiscal measures are necessary to ensure the output and income losses and the increases in unemployment are kept to a minimum.

In the period after Maastricht, the European Commission published several research papers which aimed to show that sufficient stabilisation could occur at the national level to avoid crisis. The research papers that were summarised in the One Money, One Market publication (European Economy, 1993) used various ‘Neo-Keynesian’ economic models to compare the role of central budgets in the US and Canada, for example against what occurred in say France and Germany. The simulations were deeply flawed.

For example, simulations’ produced by their own economists Alexander Italianer and Jean Pisani-Ferry (1992) claimed that the new EMU would not need a large federal budget because sufficient ‘stabilisation’ (via automatic stabilisers) would be forthcoming at the national level. In a related paper, Pisani-Ferry et al. (1993), perform a similar analysis using what they admit is a “highly simplified” model (p. 519) that they calibrate (set up) with the ‘Mimosa multinational model’, which is a standard Neo-Keynesian model of the economy developed by two French research centres – CEPII (Centre d’études prospectives et d’informations internationales) and the OFCE (observatoire français des conjonctures économiques). They tell us that the “model responses followed as expected the standard neo-Keynesian pattern, so there is no need to comment upon simulation results” (p. 521). In other words, as a result of the assumptions and parameters employed in the simulation, the authors basically knew what the results would be before the fact.

In the aftermath of the Global Financial Crisis, it is now more generally understood how deficient these types of economic models are. For example, the basic Neo-Keynesian models excluded the banking and financial markets as unimportant and thus had nothing to say about the likelihood of the financial crisis even though the risks were there for all to see prior to the crash (see Mitchell and Muysken, 2008). Even a mainstream economist like Willem Buiter (2009) considered these models to be “useless”:

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck …

Buiter’s list of economists include those who were regularly cited as authorities by the European Commission economists and consultants in justifying their support for the Maastricht EMU design.

More recently, Pisani-Ferry et al. (2012: 3) noted that while all “federations have sizeable federal budgets … the founders of Europe’s monetary union … eventually decided that in Europe, stabilisation policy could be exercised at the national level”. The calculations they used assumed that “automatic stabilisers could fully react to a 6 percent decline in output before the 3 percent Maastricht deficit level was reached. It was judged that a 6 per cent decline in GDP was very unlikely” (p. 3). They acknowledge that the GFC has proven these assumptions were in correct. Pisani-Ferry et al. (2012: 2) acknowledge that “When bad times … came … the buffer proved too small. In the course of two years, from 2007 to 2009, Spain moved from a 2 per cent GDP surplus to an 11 percent deficit; Ireland went from balance to a 14 percent deficit”.

The experience clearly demonstrated the validity of the insights that were first articulated formally in 1968 by Wallace Oates (Oates, 1968). Relying on regional governmental units to provide fiscal support when a nation is hit with a major decline in spending will fail to militate against recession.

But the European Commission were warned of this even before Stage III was finalised. After the SGP was agreed to at the European Council meeting in Dublin in December 1996, three Commission economists performed a “retrospective” evaluation of how the the SGP would have performed in the period between 1961 and 1996 (Buti et al., 1997). In other words they analysed the factual fiscal outcomes over this period against the rigid SGP rules, especially in terms of considering “what types of recessions” would lead “Member States into a position of excessive deficit” under the Maastricht rules (p. 1). The point of the exercise is that the earlier work in the 1990s, which sought to give ‘authority’ to the Maastricht design claimed that it would be difficult for the SGP rules to be violated without the intent of the government to overspend – that is, to be violated purely by the impact of the automatic stabilisers.

Their exercise found that between 1961-1996:

1. There were 24 severe recessions identified among the 15 member states of the EU at the time according to the SGP criteria of a GDP decrease of more than 0.75 per cent. The average decline in real GDP (output) was 2.5 per cent.

2. On average, the output gaps (the departure from trend output) was 5.5 per cent over this period.

3. While the increase in the fiscal deficits varied for each identified episode the average increase was 3.6 percentage points. Almost all of the increase was due to the automatic stabilisers (on average 3.5 percentage points).

4. Assuming an average starting point deficit of 2 per cent before the recession struck, in 18 of the 24 episodes identified, the resulting increase in the deficit would have been considered an ‘excessive deficit’ under the SGP rules.

The authors concluded that the “risk of incurring an excessive deficit is high in case of protracted recessions” even if the starting point is a balanced fiscal position and that the “same conclusions can be drawn for exceptionally severe recessions with negative growth of 2% or more” (p. 29). The risk of breaching the SGP thresholds was thus identified to be high unless the nations undertook “a pro-cyclical budgetary stance” (p. 29).



Additional references

This list will be progressively compiled.

Andrews, E.L. (1997) ‘German’s Slick Bookkeeping to Meet Euro Goal Is Scrapped’, New York Times, June 4, 1997. http://www.nytimes.com/1997/06/04/world/germans-slick-bookkeeping-to-meet-euro-goal-is-scrapped.html

Böll, S., Reiermann, C., Sauga, M. and Wiegrefe, K. (2012) ‘Operation Self-Deceit: New Documents Shine Light on Euro Birth Defects’, Der Spiegel, May 8, 2012. http://www.spiegel.de/international/europe/euro-struggles-can-be-traced-to-origins-of-common-currency-a-831842.html

Buiter, W. (2009) ‘The unfortunate uselessness of most ‘state of the art’ academic monetary economics’, Financial Times, March 3, 2009. http://blogs.ft.com/maverecon/2009/03/the-unfortunate-uselessness-of-most-state-of-the-art-academic-monetary-economics/

Buti, M., Franco, D., and Ongena, H. (1997) ‘Budgetary Policies during Recessions – Retrospective Application of the “Stability and Growth Pact” to the Post-War Period’, Economic Papers, 121, 1-33. http://ec.europa.eu/economy_finance/publications/publication11240_en.pdf

Deutsche Bundesbank (1998) ‘Stellungnahme des Zentralbankrates zur Konvergenzlage in der Europäischen Union im Hinblick auf die dritte Stufe der Wirtschafts- und Währungsunion’, April 1998. http://www.bundesbank.de/Redaktion/DE/Downloads/Veroeffentlichungen/Monatsberichtsaufsaetze/1998/1998_04_konvergenzlage.pdf?__blob=publicationFile

Dunbar, N. and Martinuzzi, E. (2012) ‘Goldman Secret Greece Loan Shows Two Sinners as Client Unravels’, Bloomberg News, March 6, 2012. http://www.bloomberg.com/news/2012-03-06/goldman-secret-greece-loan-shows-two-sinners-as-client-unravels.html

Eichengreen, B.J. (1997) ‘Saving Europe’s automatic stabilisers’, National Institute Economic Review, 159(1), 92-98.

Eichengreen, B.J. and Wyplosz, C. (1998) ‘The stability pact: more than a minor nuisance?’, Economic Policy, 26. 65-114.

European Central Bank (1998) ‘Joint communiqué on the determination of the irrevocable conversion rates for the euro’, May 2, 1998. http://www.ecb.europa.eu/press/pr/date/1998/html/pr980502.en.html

European Monetary Institute (1998) ‘Convergence Report’, March 1998. http://www.ecb.europa.eu/pub/pdf/conrep/cr1998en.pdf

EurActiv (2010) Theo Waigel: Greek crisis exposed EU weaknesses’, September 13, 2010. http://www.euractiv.com/euro/waigel-stability-pact-not-flawed-all-countries-must-play-rules-news-497698

European Council (1997a) ‘Presidency Conclusions’, Amsterdam, June 16-17, 1997.

European Council (1997b) ‘Resolution of the European Council on the Stability and Growth Pact Amsterdam, 17 June 1997’, Official Journal C 236, 02/08/1997 P. 0001 – 0002. http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31997Y0802%2801%29:EN:HTML

European Council (1998) ‘Presidency Conclusions’, Vienna, December 11-12, 1998. http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/00300-R1.EN8.htm

European Monetary Institute (1998) ‘Convergence Report’, March 1998. http://www.ecb.europa.eu/pub/pdf/conrep/cr1998en.pdf

Italianer, A. and Pisani-Ferry, J. (1992) ‘Systèmes budgétaires et amortissement des chocs régionaux : implications pour l’union économique et monétaire’, Economie prospective internationale, 51, 49-69. http://www.cepii.fr/IE/PDF/EI_51-4.pdf

Jean Pisani-Ferry, J., Italianer, A. and Lescure, R. (1993) ‘Stabilizatoin properties of budgetary systems: A simmulation approach’, in The Economics of Community Public Finance, European Economy, Reports and Studies, 5.

Pisani-Ferry, J., Vihriälä, E. and Wolff, G. (2012) ‘Options for a Euro-Area Fiscal Capacity’, Bruegel Policy Contribution, Issue 2013/01, January. http://www.bruegel.org/download/parent/765-options-for-a-euro-area-fiscal-capacity/file/1636-options-for-a-euro-area-fiscal-capacity/

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

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