Replace Europe’s Growth and Stability Pact with Market Discipline and Democracy

As part of the euro’s introduction, European governments agreed to constrain their budget policies through the Growth and Stability Pact. Though euphemistically termed the “growth and stability” pact, it in fact delivers neither. Moreover, owing to the constraints the pact places on national economic sovereignty, it risks contributing to political strains that threaten to undermine support for the euro. For these reasons, it is time to abandon the pact. In its place, Europe should let democracy and financial markets arbitrate the long-term viability of government fiscal policies.

Under the terms of the pact, euro member countries agreed not to run budget deficits exceeding three percent of national income (gross domestic product). The justification for the pact was that it was needed to build confidence in the new European currency. In particular, it was needed to address market fears of rogue governments running excessive deficits, thereby either forcing other governments to bail them out or setting up an incentive for all governments to run excessively loose budget policies.

From the beginning, the pact has been controversial because it promised to reduce space for national fiscal policy (budget policies) to counter recessions. This has turned out to be the case, and ironically the pact may have actually worsened Europe’s long-term fiscal outlook. This is because governments have been constrained in their ability to use fiscal policy to fight recession. Consequently, governments have run recession-induced deficits, but these deficits have not been large enough to escape the pull of recession. The net result is that economies have gotten trapped in depressed conditions that have lowered tax revenues and created persistent deficits.

Additionally, the pact may have hurt growth by limiting investment in public capital. The three percent budget deficit constraint does not distinguish expenditures on infrastructure and public capital from other expenditures. Thus, as social expenditures have risen with unemployment, capital expenditures may have been crowded out.

Now that the euro has been successfully introduced, what gains there ever were from the pact have been reaped. At this stage it has become counter-productive, causing both economic and political damage. In particular, by constraining national policy, the euro and the European Central Bank are being increasingly blamed for poor country economic performance, creating a political brew that could undermine the euro.

Some argue that the pact still provides markets with confidence, and all that is needed is reform. The reformers advocate replacing the over-restrictive annual three percent budget cap with a cap that averages three percent over the entire business cycle. Additionally, they recommend distinguishing between capital and other expenditures, with only the latter being subject to the pact’s cap.

Though well intentioned, these reforms are fraught with problems. First, there is the difficulty of defining what constitutes a capital expenditure. Then there is the problem of governments engaging in excessive capital spending. Third, there is the problem of defining the length of the business cycle and deciding which years to include in the average three percent rule. Most importantly, there remains the political problem of the pact being an externally imposed constraint on national economic sovereignty.

A better solution is to abolish the pact. Governments that run deficits will sell their bonds on financial markets, and markets will then price these bonds according to the viability of country fiscal policies. Side-by-side, the European Central Bank (ECB) should set benchmark interest rates aimed at facilitating high employment in Europe, which would help reduce budget deficits. The ECB would also agree to only purchase those government bonds with the highest investment grade rating, thereby preventing fiscally irresponsible governments from circumventing financial markets and forcing the ECB to finance them. Finally, the amount of debt of any member country that an individual private financial institution can hold should be limited, thus blocking governments from forcing client banks and pension funds to buy their debt.

State governments (such as California and Texas) in the United States finance their deficits by selling bonds, and the market charges interest rates on the basis of perceived long-term viability of budget policies. That system of market discipline works well, and it should be adopted by Europe. Governments that run large unsustainable deficits will be charged higher interest rates to compensate for higher default risk. So too will companies in those countries because of fears of a future fiscal crisis forcing higher taxes and recession.

Such market outcomes in turn promise to trigger democratic disciplines that control governments. Voters dislike paying higher interest rates and having their taxes used to service government debt, which creates political incentives for sustainable national budget policies. This is a case of markets and democracy working well together, and this pairing is the solution to Europe’s budget policy conundrum.

Of course, eliminating the Growth and Stability Pact is just a small part of making the euro work better. Beyond that there is the more important challenge of building the pan-European automatic stabilizers and economic floors that are needed given Europe’s move from national currencies to a single currency. However, that is another subject for another article.

4 Responses to “Replace Europe’s Growth and Stability Pact with Market Discipline and Democracy”

  1. John Konop Says:

    Economists Are Destroying America

    Economists, politicians, and executives from both parties have promised American families that “free” trade policies like NAFTA, CAFTA, and WTO/CHINA would accomplish three things:

    • Increase wages
    • Create trade surpluses (for the US)
    • Reduce illegal immigration

    Well, their trade policies have been in effect for about 15 years. Let’s review the results:

    • Declining real wages for 80% of working Americans (while healthcare, education, and childcare costs skyrocket)
    • A record-high 46 million Americans who don’t have health insurance (due in part to declining wages and benefits)
    • Illegal immigration out of control
    • Soaring trade deficits, much with countries that use slave and child labor
    • Personal and national debt both out-of-control
    • Global environments threatened by lax trade deal enforcement

    Economists Keep Advocating Policies That Aren’t Working

    Upon seeing incontrovertible evidence of these negative trade agreement results, economists continue with Pollyannish blather. Some say, “Cheer up! GDP is up and the stock market’s doing fine.” Others say, “Be patient. Stay the course. Free trade will raise all ships.”

    Even those economists who acknowledge problems with trade agreements offer us only half-measures—adjusting exchange rates, improving safety nets, and providing better job retraining. None of these will close the wage gap in America—and economists know it.

    Why Aren’t American Economists Shouting From Street Corners?

    America needs trade deals that support American families and businesses in terms of wage, environmental, and intellectual property abuses. Why aren’t economists demanding renegotiation of our trade deals? There are three primary reasons:

    • Economists are too beholden to corporations and special interests that provide them with research grants.
    • Economists believe—but refuse to admit—that sacrificing the American middle class is necessary and appropriate to generate gains in third world economies.
    • Economists refuse to admit they make mistakes.

    Economic Ambulance Chasers

    Now more than ever, Americans need their economists to speak truth and stand up to their big business clients. Instead, economists sound like lawyers caught chasing ambulances: they claim they’re “doing it for our benefit”.

  2. David Bunnett Says:

    Mr. Palley—I always enjoy your posts. Your writing is clear, intelligent, honest, and other good things. You do a great job of “bridging” the communications gap to a non-economist like me.

    In my perception, you seek to advance progressive values by identifying pragmatic, politically viable solutions to real world problems. I look forward to the day when you are offered a policy making position.

  3. Eladio Febrero Says:

    Just a qualification and a comment.
    European authorities strongly believe that the Stability and Growth Pact (S&GP) points to the right direction. In their opinion, what is missing is an even deeper liberalization of labour markets (and other markets as well). Thus, Mr Palley is right when he says that some argue that it is necessary to introduce minor reforms to the S&GP. However it is, I believe, incomplete.
    Additionally, Mr Palley defends the idea that nations should be allowed to run deficits and sell bonds in financial markets. Alternatively, many people here in Europe prefer implementing a true European fiscal authority, i.e. a supra-national institution able to run deficits backed by the European Central Bank. Unfortunately, there are serious obstacles in this path towards the European integration.

  4. kurt bayer Says:

    Thomas seems to misunderstand the intentions and the mechanism of the SGP: to invoke the issue of restrictions in national sovereigny misses the point that the introduction of the Euro for 12, now 13 countries, has already eliminated the possibility of national monetary policy. In order to create an “optimal” monetary-fiscal policy mix for the Euro area, Eurozone fiscal policy and monetary policy must be aligned. This was the intention of the original pact.
    The conundrum is that monetary policy has been centralized, but fiscal policy remains national, but restrained through the SGP.
    The real problem is not the 3% ceiling - historically this has been breached only very rarely, but rather the fact that during cyclical boom times Eurozone countries have not consolidated, thus starting from too high a budget deficit when recession hit.
    As the data show, financial markets in Europe have not really punished deficit “sinners”, thus the solution, to let the markets work, is not viable yet. Maybe some time in the future.
    The new formulation of the SGP puts more pressure on countries to consolidate “in good times”, the forthcoming evaluation and implementation will show how well that works.
    A large number of European economists share my view that the major problem with the policy mix in Europe is the subjugation of Eurozone fiscal policy under the ECB’s iron regime and that - so far - finance ministes have not been able to talk ECB into a regular and even-level dialogue.