Europe’s Perilous Quest For Stability

Joerg bibowEurope’s currency union is built on two key principles. The first is that the central bank must be independent of political control and its policies squarely focused on maintaining price stability. The second is that fiscal policy must be disciplined and never threaten price stability. Price stability, in turn, is the foundation for economic stability and prosperity. These principles and ideas are of German origin. And they distill the gist of Germany’s post WW2 economic history, an economic success story featuring both stability and growth.

The German success story was meant to be replicated at the European level. The European Central Bank copycatted the Bundesbank. As Germany’s constitution featured a “golden rule” limiting public budget deficits to public investment, a fiscal pact was to safeguard the ECB by decreeing budget deficits in excess of three percent of GDP as excessive and prescribing their speedy reduction. That pact was named the “Stability and Growth Pact” reflecting the German belief – based on historical experience – that fiscal and monetary discipline go along with both stability and growth.

Things have not played out according to script for Europe. And the fact that harmonized consumer price inflation has somewhat exceeded the ECB’s two-percent norm defining price stability for most of the time is not the issue here. Rather, the point is that the area’s economic performance record is one of instability and stagnation (or worse).

Almost by reflex the German and euro authorities put the blame for these dismal outcomes on an apparent lack of fiscal discipline. True, public debt ratios have surged since 2008, and with few exceptions eurozone member countries have confronted “excessive deficit procedures”. So the fiscal pact was strengthened in response and public debt ratios in excess of 60 percent of GDP are now required to converge to the supposed stability threshold at some speed. Viewing public debt as the ultimate threat to stability, a “Fiscal Compact” was agreed which requires countries to anchor a “balanced budget” rule in national law. With balanced budgets countries would actually see their public debt ratios eventually converge towards zero – assuming GDP growth stays positive.

Germany, the main force behind these reforms and leader by prudent example, replaced its former “golden rule” by a new “debt brake” that constitutionally limits the structural budget deficit to 0.35% of GDP at the federal level while also requiring balanced budgets at lower levels of government. Given its apparently strong creditor position, Germany’s stability fixation is a rampant force across the continent today. Essentially, Europe’s currency union is trying to address its peculiar lack of fiscal union by banning budget deficits altogether.

This constitutionalized witch hunt for public debt is calling for serious trouble. While the devastating consequences of austerity are highly visible, the illusion prevails that the damages would be short-lived. The jury is in on the G-20 dispute that arose in 2010 on whether aggressive austerity would risk derailing the still fragile recovery. Europe underwent the test, and failed dismally; with myths about expansionary fiscal contraction being drowned by depressing facts. The IMF rediscovered that the size of fiscal multipliers depends on the economic situation. To the extent that there was ever any actual evidence of expansionary contractions, the lucky ones were small, open economies that could offset fiscal contraction by monetary easing and a more competitive exchange rate. With mindless austerity practiced across the continent, there is no offset other than by courtesy of the rest of the world. This is why talks about “currency wars” are getting louder also among advanced economies.

But fears of currency warfare are just a foretaste of things to come. For the devastating economic consequences of Europe’s perilous quest for stability are not just a short-term affair. Europe’s Qixotic ambitions to forever balance public budgets and drive public debt out of the system has serious long-term implications too.

These may be best understood in terms of the sectoral financial balances approach championed by the late Wynne Godley. Think of the economy as consisting of three major sectors: public, private, and the external sector. Aggregating all incomes and expenditures for each sector yields three financial balances. For the economy as a whole the three sectoral balances must always add up to zero – by accounting identity. By implication, as Europe’s currency union requires its public sector balance to be zero, the sum of the remaining two sectoral balances must add up to zero too. In other words, under the eurozone’s fiscal constitution, the private sector can only be a net saver (achieve a surplus in its financial balance), if the eurozone runs a current account surplus.

Germany’s own experience of successfully balancing its public budget balance did not come along with surging current account surpluses by pure accident. The simple truth is that if your private sector is a net saver, as is the case in Germany, the public sector can only balance its books by means of current account surpluses. Alas, Germany’s success with that endeavor has saddled its currency union partners with massive debt overhangs – the source of today’s euro crisis.

Since the eurozone’s private sector too is a structural net saver, tightened fiscal screws are effectively turning the eurozone into a larger Germany aspiring for perpetual current account surpluses. As Europe is still too large to follow the German model of export-led growth, Germany’s fiscal folly has become an institutionalized threat to global stability.