In yesterday’s column on the Merkel-Sarkozy economic governance proposals I briefly criticised the idea of writing a debt brake/balanced budget rule into the constitutions of euro area member states. It is a crucial point and the arguments deserve to be set out more clearly. At least four arguments need to be made: consistency with sectoral (im)balances, public investment, uncertainty about the cycle and the risk of pro-cyclicality, and policy lock-in.
As George Irvin rightly points out on this site, the idea doesn’t add up at the level of basic national accounting identities. If all countries run a balanced budget and their respective private sectors run surpluses, which is normal in capitalist economies, then the euro area as a whole must run a persistent and probably substantial current account surplus with the rest of the world. This will almost certainly not happen: there will be offsetting reactions (currency appreciation, protectionism) that will limit the extent and/or duration of any such current account surplus, forcing adjustment by the public sector. True, it is possible that the private sector goes into deficit, i.e. continually spends more than it earns. This is what happened in the US in the second third of the 2000s, and we all know how wonderfully that ended.
The basic point is that the government balance is not, as usually thought, a policy variable that can simply be targeted at will. Attempts to achieve any given target lead to adjustments by other actors. Fiscal targets can only be met if they are consistent with what other actors want. For this reason it makes much more sense to evaluate the position of the public and private sectors of a country together. Experience shows that continuous small public deficits, on average over the cycle, offer the best chances for sustained growth and high employment. Even if we take that fiscal paragon, Germany, we see that since 1960 (and estimating conservatively by stopping at 2008 and excluding some ‘creative accounting’ in the context of unification) it has on average posted an annual deficit of more than 1.6% of GDP. (Source: AMECO, net lending as % of GDP, some splicing necessary.) And remember, this is a country that has run up substantial current account surpluses that are not feasible at the level of the euro area as a whole.
This is related to another important weakness of the debt brake/balanced budget proposal: the failure to distinguish current spending and investment. There is no economic logic whatsoever for financing investment out of current revenue. The very minimum demand, then, of any balanced budget rule would be that it explicitly refer to balancing current and not total spending over the cycle. This raises the not trivial issue of distinguishing the two. As a practical matter, if we simply take the standard European statistical definitions, public investment is of the order of 2-3% of GDP a year. I would argue that it should be substantially higher, but even if, say, 3% was taken as the ceiling for a sensible average deficit across the cycle, we see how far off the mark the SGP (maximum deficit of 3% in any one year) or the idea of a zero percent average government balance are. It is worth noting that this figure is also in the same ballpark as interest payments on government debt in normal times. (Probably a little higher in fact; it implies for example a debt to GDP ratio of 100% and an interest rate of 3%. Currently both numbers are lower for the euro area.) Thus the primary balance would be zero or positive, meaning that the debt to GDP ratio would tend to stabilise or fall. (Yes, you can run permanent fiscal deficits. See here for an explanation, or just think “Germany has”.)
Third, it sounds sensible to call for a balanced fiscal policy ‘across the cycle’. However business cycles can only be reliably identified ex post. In fact even here there is scope for disagreement. When setting fiscal policy in real time, policymakers do not know at which point in the current cycle they are, or how long a current stagnation or boom phase will continue. For example, on emerging from the 2001 recession Germany experienced a long stagnation phase. Under the debt brake rules that it subsequently introduced it would have been forced at some point to tighten fiscal policy. The IMK institute estimates that this would have been highly costly in terms of output and jobs, on top of the already difficult situation Germany was in in the mid-2000s. (German readers siehe hier.) Conversely, around 2006/7 the UK was seen by the then government, and many experts, as being in a phase of steady expansion, and not, as subsequently became clear, on an unsustainable path. In short the precise operationalisation of any fiscal ‘golden rule’ is fraught with difficulty. Such constraints sharply increase the risk that governments will pursue pro-cyclical austerity policies in order to avoid the risk of running foul of the constitution. That, of course, is what proponents of the debt brake want, but as we have seen they have not thought through the economic implications. Substantial employment and output losses may result, and the impact would be magnified if all or many euro area countries would be applying contractionary policies at the same time.
This is then related to the final point: it makes no sense to include in a country’s constitution, which should be reserved for more or less immutable statements of principle and broad divisions of institutional powers and basic rights, complex regulations governing fiscal policy, regulations that may well have to be changed in the light of experience or circumstance. Of course you can easily include very simple rules: for instance there is no legal problem in categorically banning the national government from ever borrowing on the capital markets. But that would be economic madness. (Yes, some US federal states have such rules, but they are backstopped by the federal government. This is precisely what Europe lacks.) Any half-way sensible rule will be highly complex. (The not half-way sensible Schuldenbremse certainly is.) If at all, fiscal rules should be passed in the form of standard legislation, so that they can be adapted if necessary by the normal parliamentary process. It would be a huge error to saddle future generations with an untried and, as shown above, potentially dangerous legal mechanism which can only be changed with great legal difficulty and at high political cost. (The latter because gaining the super-majorities normally needed to amend constitutions hands power to parliamentary groups representing sectional interests who then need to be ‘bought off’.)
Generalising a debt brake to all euro area countries is bad politics and bad economics. This part of the Merkel-Sarkozy proposals should be fought resolutely by all those interested in sensible economic government reform and decent economic outcomes in Europe.