Replace Europeâ€™s Growth and Stability Pact with Market Discipline and Democracy
As part of the euroâ€™s introduction, European governments agreed to constrain their budget policies through the Growth and Stability Pact. Though euphemistically termed the â€œgrowth and stabilityâ€ 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 Europeâ€™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 pactâ€™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 Europeâ€™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 Europeâ€™s move from national currencies to a single currency. However, that is another subject for another article.