The European Commission has presented draft legislation that, if adopted by the European Parliament and the European Council, would mark the biggest reform of economic governance in Europe since the start of monetary union. Europe urgently needs to reform its system of economic governance. But it does not need these proposed changes. While marking progress in some important areas, they are a step backward in others and, above all, a missed opportunity to use the crisis to make changes that would enhance growth and employment opportunities in Europe and raise the welfare of Europe citizens. In this form, the Parliament and Council should not ratify them.
Europe’s economic governance reform needs
To see why, let’s start by considering what economic governance reforms Europe really needs in order to emerge from the crisis, and beyond that, enjoy an extended period of growth that is economically, socially and ecologically sustainable. Or, if you prefer, what have we learnt from ten years of EMU and from the economic and financial crisis regarding the way Europe’s economies, and the European economy as a whole, are managed? Leaving aside financial markets, I would argue that the following eight lessons – there are certainly others – are crucial:
- Annual government deficits, even structurally adjusted, are a bad guide as to how a country is performing and whether it is acting appropriately in view of the needs of EU partners; and the same is true of debt levels, as the cases of Ireland and Spain clearly show. Consequently, simplistic quantified fiscal targets are not helpful. At the same time the stance of the private sector (businesses and households), and in particular its debt position, disregarded until now, is an important policy consideration. Both imbalances must be examined together.
- Even within a monetary union, large and persistent current account surpluses and deficits are dangerous and they are systematically promoted by the way that monetary union works. Consequently, coordination mechanisms to ensure appropriate unit labour cost and price developments are needed.
- Strong automatic stabilisers and discretionary counter-cyclical fiscal policy are needed to address both asymmetric shocks and, in conjunction with monetary policy, area-wide booms and busts.
- The fiscal policy spillovers between countries are not just ‘negative’ (deficits in one country push up interest rates for everyone), but also ‘positive’ (expansionary fiscal policy boosts demand in other countries).
- Tax competition undermines the basis for government revenues and increases inequality.
- Punitive sanctions, envisioned under the Stability and Growth Pact (SGP), cannot be imposed on countries that are in economic difficulties. Instead, such countries require the solidarity of other E(M)U members in order to prevent contagion effects. This is best organised in the form of a standing crisis resolution mechanism.
- Monetary policy sometimes needs the support of coordinated fiscal policy (for instance when at the zero bound), and the reverse is also true (for example when indebted countries face high interest rates on public debt).
- Last but not least, a myopic focus on micromanaging consumer price inflation is not always an appropriate sole rule for monetary policy.
The Commission’s legislative proposals
The Commission’s legislative drafts, which build on earlier proposals (discussed here) and are supposed to contribute to the EU’s medium-term 2020 strategy (discussed here), make very little progress in converting these lessons into practical policymaking, and in some areas are worryingly regressive. The proposals can be summarised in three points:
- The surveillance of fiscal policy under the SGP is reinforced further, notably by insisting on the respect of the debt criterion (60% of GDP) or a rapid pace of downward adjustment towards it (one twentieth of the gap between the current and target levels per year). The medium-term objective (MTO) of being ‘close to balance or in surplus’ is retained, but this is now specified to be achieved by focusing on government spending rather than revenues. The sanctions regime is tightened, coupled with a measure (the so-called reverse voting mechanism) that makes it harder for member states to block a Commission recommendation to impose sanctions.
- The surveillance of member states is also to be broadened, notably by incorporating an assessment of competitiveness and current account positions against a ‘scoreboard’ of relevant indicators. Modelled on the excessive deficit procedure in the SGP, an excessive macroeconomic imbalances procedure is to be instituted, which leads to country-specific recommendations by the Commission. If ignored, these can also result in financial sanctions imposed by the Council.
- The coordination processes are to be streamlined in a new annual procedure known as the European semester. This has already been adopted by the Council, and so strictly speaking is not part of the legislative package, but it is an integral part of the reform.
What’s good about the proposed reform package? Essentially two things: In substantive terms the issue of macroeconomic imbalances is recognised as being of key importance for a coherent and sustainable economic strategy in Europe; and a procedure for assessing and, ultimately, correcting them has been established. At the procedural level, the European semester promises to intensify the degree of policy coordination in Europe by establishing a common policymaking framework and timetable (see here for more details). These are important steps forward towards the needed coordination of economic policymaking in Europe. However, they are not enough to outweigh what is bad and what is missing.
The centrepiece of the reform is a heightened focus on fiscal consolidation. Something akin to Germany’s ‘debt brake’ (Schuldenbremse) is to be instituted across Europe. This is bad for a number of reasons. Excessive fiscal profligacy was not a cause of the crisis, and is really only a critical problem in Greece (and even there on the revenue rather than the spending side). High fiscal deficits and debt are the result of the crisis – inevitable and indeed desirable. Certainly, they should be reduced, but it is completely wrong to focus what is supposed to be a long-term reform of economic governance mechanisms on what is one single and medium-term policy requirement. Moreover, in the shorter run, if the injunction to reduce structural deficits by 0.5 percentage points (p.p.) a year and government debts on average by around 1 p.p. a year – indeed twice that in some countries – is taken seriously, the European economy will likely suffer a ‘lost decade’, if not worse. In such a context, the new sanctions will not be worth the paper they are written on; they will be inoperable.
The proposed focus on the spending rather than the revenue side is unjustified, not least in the light of the problem of tax competition, which is not addressed at all by the proposals. The recommendation, if followed, will lead to a steadily declining relative size of the public sector. Yet, this and, more generally, the mix of measures on the expenditure and revenue side, can only be decided by democratically legitimated (national) parliaments and not by an unelected bureaucracy. This is a recipe for conflict between member states and the Commission that I cannot see the latter winning, even under the proposed new voting procedures.
Then there are two important sins of omission. No attempt is made when calculating deficits to allow for public investment spending that raises potential growth rates and thus promotes, in the medium run, fiscal consolidation. To see how crazy this is, imagine an investor who cannot distinguish between two otherwise identical firms, one of which invests €10 million in the latest production machinery, the other the same sum buying the CEO a yacht or a private jet. Governments facing political strictures to cut deficits and debt will slash public investment, as this is easier and quicker than reducing statutory entitlements. This is what happened in the run-up to EMU in many countries. It is economic vandalism, entirely unjustified by any sensible economic theory, and completely incompatible with promoting the goals of the EU2020 strategy (as I have pointed out before). Perversely, there is one exception to this logic (or rather illogic): countries that use tax subsidies to promote capital funded pension schemes are to be permitted to set such spending against their deficits. This is special pleading of the worst sort. In contrast to, say, investment in R&D or smart energy infrastructure, it is very dubious that such spending should sensibly be considered an investment.
Similarly, no measures to incentivise countries to strengthen their automatic stabilisers are envisioned, although there is a clear European value-added to such coordinated efforts, which would make a major contribution to stabilising demand and output.
Criticising the package is not just a mater of identifying a lack of ambition. Ideally, Europe would need a mechanism for establishing the desired aggregate fiscal stance given the expected economic situation and, then, the appropriate allocation of national fiscal positions, such as to take account of national and the overall European requirements. This would almost certainly involve some (limited) fiscal transfers between countries. Clearly that is a tall order, and I would not be so critical of the Commission’s proposals if it were merely that they move ahead with excessive caution: of course there are many real-world legal and political obstacles to instituting an ideal governance system. But by focusing on fiscal issues, and intensifying the pressure on national policy to achieve a uniform medium-term objective for fiscal policy of ‘close to balance’, while ignoring sensible reforms like taking out investment, the Commission is, if anything, taking us away from that ideal.
The close-to-balance rule, however sensible it may appear at first sight, has implications that are not always benign and can, under realistic conditions, be highly damaging. First of all, they imply zero government debt in the longer term. There is no sound economic argument why that is optimal, and no government of an advanced country has come even close to being debt-free since the dawn of capitalism. Moreover, adhering to such a rule forces the two other sectors, the private sector and the external balance to precisely offset each other. If desired national savings are higher (or lower) than investment, then the current account will be in surplus (or deficit) to precisely the same degree. If, under the ‘excessive macro imbalances’ procedure, these are to be prevented, then the private sector will be forced to adjust. The imbalance between desired savings and investment will be forcibly rectified by lower output growth. Even if it seems counter-intuitive from the point of view of an individual, this is why it is actually sensible for governments to post repeated (but sustainable) deficits year-in, year-out.
This brings us back to external imbalances, recognition of the importance of which I praised earlier. The problem is that, because of the interaction of sectoral balances, the reform proposals are actually incoherent. The only sensible solution is to focus primarily on the external (i.e. current account) balances, which have been shown by the crisis to make countries so vulnerable, and as part of that to examine fiscal positions, rather than to prioritise the public over the private sector (im)balance. In other words, the debt position of the public and private sectors (which together are equal and opposite to the current account position) of each country should be examined in equal measure, at the same time and in one single procedure. Such an examination would quickly reveal that, in most countries most of the time, it is changes in private savings and investment behaviour, rather than public debt, that are the prime source of imbalances. More importantly in policy terms, it would foster Europe’s economic recovery by leading to sensible policy recommendations, notably that countries with large surpluses on current account (above all Germany) should continue with stimulus measures, while deficit countries consolidate earlier.
Although the macro imbalances part of the proposals constitutes an important step forward, concerns remain even here. One is repeated language that implies that current account deficits are worse than surpluses, rather than their counterparts, and adjustment is the sole responsibility of deficit countries. Another is the measures foreseen. The proposed scoreboard is ill-defined and risks making the opposite mistake to the simplistic fiscal targets: being open to any number of interpretations. Of concern is that the entire process appears to be based on an interaction between the European Commission (read: DG Ecfin) and national governments (read: finance ministries). Yet, key to competitive imbalances are wage and price developments, and thus labour markets and collective bargaining institutions. They are the responsibility of other actors, but there is no indication of how they are to be incorporated. The EU has an institution, the Macroeconomic Dialogue, which could be strengthened and expanded to help coordinate adjustments of nominal wage and price trends. Yet, inexplicably, there is no mention of this in the proposals. It seems that policymakers are sticking to the faith that, if only there is enough ‘structural reform’, wage and price settings will become so ‘flexible’ that adjustment will be achieved via competitive pressures. The most benign interpretation of this is that it is the triumph of hope over the experience of ten years of EMU.
So far, we have considered missing elements within policy areas actually addressed by the reform proposals. Given that the legislative proposals are touted as a reform of economic governance, it is somewhat surprising that there is not a single mention of the role of monetary policy within the broader economic governance framework. The ECB was seemingly created in some secular version of the ‘immaculate conception’, and as such, the crisis has no implications for its conduct. Yet this is obviously incorrect. Two examples, one from the past, one from the present: The focus on fine-tuning inflation by the world’s leading central banks did not prevent the second-largest crisis of capitalism, recently estimated to have cost the equivalent of at least one entire year’s global output. And we now have a situation where the ECB lends money to banks for virtually nothing. The banks lend it to national governments at up to eight percent, a debt which has to be serviced by hard-pressed tax payers. Banks pocket the difference entirely risk free, because the ECB then takes the bonds the banks have purchased as collateral for further free bank-loans. These super profits are then distributed to shareholders and executives as dividends and bonuses.
The ECB cannot simply be treated as sacrosanct. Inflation targeting could be supplemented by more explicit mandates to consider financial stability, growth and employment. The looting of taxpayers by banks, with the ECB as accomplice, could be stopped overnight, if the ECB simply extended credit to national governments (directly or indirectly through some support scheme). Addressing such crucial issues would require a genuine reform of Europe’s economic governance rules. Instead, what is on the table is to a considerable extent an intensification of a long-standing, but evidently unjustified and unhealthy, obsession with fiscal deficits and debt, plus a basically sensible, yet flawed, extension to macroeconomic imbalances.
The reform proposals clearly do not represent an appropriate response to the main lessons, set out above, that we have learnt from ten years of monetary union as well as from the economic crisis. More worryingly, the combination of the good, the bad and the missing could potentially prove very ugly, given the state of public finances and of the economy. If accepted in their current form, the proposals carry a high risk of perpetuating economic stagnation in Europe, torpedoing the EU2020 strategy and leading to tensions and conflicts that will lead to political disintegration rather than the needed integration.
The next step in the political process will be a decision by the Council at the end of October. That leaves less than a month to campaign for amendments. And we know that the Council is dominated by centre-right governments and that Germany is already publicly committed to the package. After that, we are in the hands of the European Parliament. The issues may seem technical and abstract, but they are of critical importance for Europe’s future and must be made a priority for progressive forces in Europe in the coming weeks and months. Concrete and creative alternative proposals to, for example, take account of public investment, develop the Macroeconomic Dialogue, bring monetary policy into a genuine economic governance and provide balanced incentives and credible sanctions for good behaviour need to be put on the table and fed into the public debate.