During the decades immediately following the Second World War, macroeconomic policy operated within an analytical consensus in Europe and North America. Central banks used monetary policy to maintain positive and low real interest rates, and to support fiscal policy. Fiscal policy played a dual role, providing output and employment stability over the economic cycle, and financing public investment to complement private sector capital accumulation in the productive sectors of economies.
Today this approach is frequently identified as “Keynesian economics”, which is accurate in the same sense that accepting the validity of the law of gravity makes one a “Newtonian physicist”, or recognizing that the earth rotates the sun identifies an astronomer as a “Copernican”. The earth does have an orbit around the sun (not vice-versa). Objects do fall towards the centre of the earth. Market economies do not have an automatic tendency to full output and employment. They require governments to implement countercyclical fiscal policy.
Physicists continue to endorse the law of gravity, and astronomers do not challenge that the Earth is planet orbiting the sun. In contrast, an alarming number of economists have abandoned common sense as well as intellectual rigor to embrace a fancifully antediluvian interpretation of market economies, that they automatically hone in on full employment and potential output. The ideology of deregulation is closely linked to this mysticism of market adjustment. It serves well the speculators of high finance and even more those reactionary political interests that seek, with considerable success in recent decades, to shift resources from the public sector to private accumulation by the rich.
A clear expression of this reactionary faith in the “natural” forces of market adjustment is the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, commonly called the Fiscal Pact. If ever there were a case of pouring kerosene onto a fire, this is it. The Fiscal Pact, now in the process of country-by-country adoption, is based on the fairy tale economics of neo-liberalism, that capitalist economies automatically attain potential output and full employment through market adjustments alone.
This is the economics equivalent of denying the operation of the law of gravity. Capitalist economies have a strong cyclical tendency. It should be the function of public policy to prevent or at least moderate the down-swings in the cycle, as well as to dampen the inflationary pressures that result from the now increasingly rare moments of over-expansion. However, the neo-liberals believe that what goes up need not come down, so no public sector intervention is required.
The infamous Maastricht criterion established the bone-headed guideline that European governments should abandon countercyclical management of their economies. It appeared to allow for some flexibility in fiscal policy by permitting overall fiscal deficits up to three percent of gross national product. In practice this three percent solution allows for no flexibility, for it implies de facto balanced budgets. The overall fiscal deficit includes interest payment on the public debt. As I have written in other articles, no professionally reputable financial organization specifies fiscal rules, even neo-liberal ones, in terms of the overall deficit (see the IMF document, “Guidelines for Fiscal Adjustment”).
The average share of interest payments in GDP for the euro zone countries during 2009-2011 was 2.6 percent, which implies that the Maastricht three percent sets a maximum expenditure (“primary”) deficit of less than one-half of one percent of GDP. Most interest payments are to private pension funds holding public bonds because they involve less risk than private bonds or equities, or to corporations and wealthy households abroad. The first is saving and the second is the equivalent of an import. To put it simply, public sector interest payments are not “expenditure” – they do not add to aggregate demand. The Maastricht Three Percent is de facto a balanced budget requirement.
In practice the rule is considerably tighter than a zero balance. During 2009-2011 public investment across the euro zone countries averaged slightly over three percent of GDP (go to eurostat.ec.europa.eu, “General Government Expenditure Statistics”). Businesses finance investment by borrowing, as do households (aka “mortgages”). The Maastricht rule requires governments to pay up-front for the construction of roads, schools, etc., out of current revenue. This is a requirement that public investments be funded twice, when they are constructed (paid from current revenue), and a second time by the flow of benefits they generate. An obvious example is a toll road. By the Maastricht requirement the government funds construction from taxes, then again from the tolls.
Far from allowing an expenditure deficit of three percent of GDP, the dysfunctional criterion requires a current expenditure surplus of three percent to double-fund public investment. Under such a rule, any government that entertained the idea of countercyclical fiscal management would need to generate a surplus well above three percent when the economy operated at normal capacity in order to expand expenditure or reduce taxes when the economy contracted. With such heavy “fiscal drag” at full employment, the economy would never arrive there (on fiscal drag, see my article with Degol Hailu).
We should not be surprised that a rule as foolish and unprofessional as the Maastricht three percent was frequently broken, though always with either some dodgy accounting to disguise the breech or faux-reassurances that the transgression was temporary. For example, the German government breeched the rule for five consecutive years, 2001-2005. The Fiscal Pact would grant the unelected European Commission power to enforce the three percent with draconian fines and austerity policy conditionalities with which we are only too familiar. A stupid rule previously honored in the breech can now be zealously forced upon twenty-seven governments.
The dysfunctionality of the Fiscal Pact only begins with the enforcement of the three percent. While over the last few years right wing politicians and the dutiful media have used the highly dubious term “structural deficit”, it appeared in no official EU document. The Fiscal Pact changes that. In perhaps its most pernicious clause the Pact requires what it calls a structural deficit to be no more than 0.5 percent of GDP. The Pact defines this creation of neo-liberal economics as follows:
A structural deficit occurs when a country is still posting a deficit… if its economy is operating at its full potential.
This definition is alleged to imply that while a “cyclical deficit” can be eliminated by economic expansion, a “structural deficit” requires changes in taxes or expenditures because if you reach full potential you still have it.
To my knowledge no one has proposed a rigorous and accurate method of measuring a country’s “full potential”. I fear that the faux-experts in the European Commission have a Friedmanite “natural rate of unemployment” in mind, which is subjective in the extreme as well as analytically invalid. But, I grant the fantasy of a generally agreed and precise measure of full potential. Even so, the definition of a “structural deficit” remains theoretically and practically unsound.
The story of the structural deficit would go as follows. A country has an overall fiscal deficit of (say) three percent, and if it were at full potential instead of where we actually find it, our calculations show that the deficit would be (say) 1.5 percent. Expenditure cuts and tax increases are required.
This is nonsense. What the deficit might be if suddenly the economy jumped from (say) eight percent to four percent unemployment is irrelevant. The question is, what would happen to the fiscal deficit over time as the economy expanded from eight to four percent unemployment. When the economy reaches the lower level of employment the deficit is 1.5 percent of GDP, continuing at that level of employment would progressively reduce that deficit toward zero. This is due to productivity increases to maintain a level of unemployment the economy must expand. As it expands tax revenue increases. With no change in either expenditure or tax rules, the deficit must decline.
The issue is not whether a deficit would exist at full potential. This fanciful formulation involves nothing more than what economics calls “comparative statics”. If deficit elimination is your fetish, the appropriate issue is, what rate of growth will eliminate a deficit in a reasonable period of time. Then you would ask, is that rate of growth in the feasible range, and what time period is acceptable to policy makers? (See my recent paper with statistics estimating that rate of growth for six euro countries).
The economics of the Fiscal Pact is rubbish, enforcing economic mismanagement upon a continent. Bad as the folly of actually forcing and enforcing bad policy might be, a much more serious danger lurks, the consolidation of the German government’s economic and political control over the European Union. It comes as no surprise that the origin the Fiscal Pact is the German government. The same government was the major force behind the austerity policies in Greece, Italy and Spanish. The Fiscal Pact would institutionalize these austerity packages.
One repeatedly reads that the deflationary economic policies of German governments over the last twenty years are a legacy of the hyperinflation of the 1920s. This seems quite dubious to me, not withstanding its repetition. First, it is quite doubtful that any living German can recall an episode that ended 88 years ago. Second, in the late 1920s and early 1930s the number of jobless exceeded six million, which was over 30 percent of the labor force. Why should the hyperinflation trauma persist more than the fear of hyper-unemployment? Third, the implication of this reiterated incantation to fears of hyperinflation is that inflation in Germany since World War II has been extremely low. This is not true. Through the 1970s consumer price inflation averaged a “raging” five percent in the Federal Republic, and was close to four percent during 1989-1993.
There is a more convincing explanation for the ideology of extreme price stability. It serves the interests of Germany’s capital to manufacture these fears of inflation. Exaggerating the danger of inflation becomes all the more credible after almost two decades of slowly growing nominal wages. When pay is not rising we should not be surprised that people notice the impact of prices. In Germany as elsewhere a pay freeze stimulates fears of inflation, whatever may have happened almost a century ago.
The Fiscal Pact would not strengthen or deepen European unity. It would strengthen and deepen German economic domination, first of the euro zone and subsequently of the European Union as a whole. It should be rejected. Save the EU. Say no to the Fiscal Pact.