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Discipline

A more specific passage from the Cohn-Bendit & Verhofstadt book that makes me mad:

 « La zone euro ne souffre toutefois pas uniquement de ce manque de solidarité. La discipline est également défaillante, alors qu’elle constitue la seconde condition nécessaire à la pérennisation d’une zone monétaire. Tous savaient depuis longtemps que les Grecs étaient incapables d’apurer leur dette, mais personne ne s’en est soucié. Quant à la France et l’Allemagne, elles ont pu enfreindre les règles budgétaires sans pour autant être sanctionnées ni mises à la amende. Soit ces pays avaient de bonnes raisons de ne pas suivre les règles, et il aurait alors fallu changer le pacte de stabilité. Soit ils avaient tort, et ils auraient dû être sanctionnés. (…) Une chose est claire : la viabilité d’une monnaie requiert de la solidarité et de la discipline. »

(p. 22)

There are several elements here, some of which are actually quite sound. It is important, however, to begin by emphasising that the Eurocrisis was not caused – in a general sense – by any lack of budgetary discipline among the Member States. Greece is a separate story. They should never have been admitted to the Eurozone in the first place, no matter how you analyse the Eurocrisis, as long as they could not even produce accurate data about the state of their economy. The detailed analysis is available in a series of posts on Paul Krugman’s blog, most importantly this one, but the general idea is that pre-crisis deficits and debt levels are a very poor predictor for whether or not a given country actually got in trouble. Spain and Ireland were doing particularly well, but still got in trouble, while France and Germany were also among the biggest sinners, but survived more or less unscathed. And this makes sense: the crisis is about current account imbalances, not debt.

It is not entirely clear to me whether, five years into the crisis, Cohn-Bendit and Verhofstadt are disputing this. After all, talking about Greece it is entirely right to focus on its lack of budget discipline. But the last sentence I quoted suggests that they still consider budget discpline to be an essential requirement for the health of the Eurozone in general, and that is quite incorrect.

The problem lies, perhaps, in the question who it is that should have “se soucié”. In the context of this paragraph, it is clear that they are thinking of the Commission and the Council here, who did not invoke art. 104 EC. However, this overlooks a much more important group: the financial markets. It is the debtholders who somehow got the impression that Greek debt was now guaranteed by the other Eurozone states, notwithstanding the very clear language of the Treaties:

The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

That’s art. 103 EC, for those who are keeping score.

Now obviously this no-bailout clause would always be less harsh in practice than in theory, but to assume that Greek debt was now almost just as risky as German debt is absurd. Any Greek payment difficulty would involve a haircut as well as a bailout, the only question being the relative size of each. Assuming, for example, a haircut of 50% means that the appropriate Bund spread for Greek debt is half of what it was before Greece’s entry into the Euro. In other words, Greece benefits, but it still pays a significant spread. The fact that it, and the other Eurozone countries that are currently in trouble, were able to borrow at such low rates for so long is a market failure, literally. And it is the banks and other investors who need to be punished for this SNAFU. The only reason why we are even talking about this is that letting the banks bear the consequences of their screw up would bankrupt them, and with them the entire world economy.

Which brings me to the one sensible point made in the quoted paragraph: “Soit ces pays avaient de bonnes raisons de ne pas suivre les règles, et il aurait alors fallu changer le pacte de stabilité. Soit ils avaient tort, et ils auraient dû être sanctionnés.” Which is it? The answer is a little bit of both: the rules make sense from a political point of view, but not from an economic one.

From an economics point of view, all that matters is that the economic development of the Member States is as highly correlated as possible; they should all have their booms and busts at the same time. In other words, it matters little whether budget deficits are high or low. Instead, they should all be low or high at the same time, and one way to do that is to force Member States to push them to zero whenever possible. But there is no particular economic virtue in a balanced budget. On average, taken over the course of the business cycle, a state may run  a budget deficit that is equal, as a percentage of GDP, to the real growth rate of GDP. Anything less than that is sustainable indefinitely. In the short term, the deficit should be above the average sustainable rate during a recession, and that shortfall should be made up during the good years. This, however, is general macro-economics. The answer from monetary economics is a heartfelt shrug.

The politicians, on the other hand, realise that implicit in this analysis is that a Eurozone member should not default on its loans. (Since that would be an extreme case of asymmetry.) It follows that some Member States – the poor ones – should be constrained in their freedom to run deficits. But since one can’t very well enact a rule of quod licet Iovi non licet bovi, the Treaty rule is that no one gets to have an excessive deficit. The overbroadness of this rule should then, in practice, be reduced by ignoring excessive deficits among healthy states like France and Germany while enforcing the rules strictly against poorer states like Greece and Portugal. But, as noted by Cohn-Bendit and Verhofstadt, such flexibility has its limits.

So does a viable monetary union require discipline in addition to solidarity? I think the correct answer is No. What it requires, instead of discipline, is a functioning system of financial markets, combined with credible signals about the form of an eventual bailout, if any. The latter should be supplied by the current crisis; if we survive this recession, everyone knows exactly what’s what. Once financial markets know exactly to what extent they can count on a bailout, they will presumably start to respond correctly to the budget deficits of various Member States. Once they do that, we will have the quod licet Iovi rule that legally isn’t possible. Financially vulnerable states get punished by the markets for running deficits, and large healthy states do not.

None of this takes away from the point about solidarity, of course. There is no question that the Member States of the Eurozone will never be able to achieve a level of correlation to make fiscal transfers unnecessary, especially given the continuing low levels of cross-border migration. We can only hope that such transfers can be achieved through less politically sensitive means than today. Likewise, various countries are going to have to think about their self-discipline with regard to competitiveness. A constant loss of competitiveness relative to Germany is simply not sustainable. Of course, Europe shouldn’t let its labour market policies be dictated by the most Calvinist common denominator either. Instead, a target level of real wage growth should be established that is achievable for all. Solidarity and competitiveness, however, are topics for another day.



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