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The 'Merkozy' Summit - Bad Politics, Bad Economics

17 Aug 2011
There aren’t many people who think the EU has responded well to the debt crisis over the past eighteen months. Responses have been slow in coming and have usually taken the form of half measures with substantive steps only arriving when political backs were slammed up against the wall by financial market panics.
 
The proposals emerging from the latest Merkel-Sarkozy meeting suggest that the key European leaders remain off the pace when it comes to containing the Euro area debt crisis. The proposals for constitutional debt and deficit limits do little to address the current debt crisis and store up many future problems.
 
Not Solving the Problem and Creating New Ones
 
While it may seem natural that something labelled the Euro area 'debt crisis' can be solved by new rules that reduce debt, there are many reasons to dislike constitutional debt and deficit rules. 
 
Take the proposals for constitutionally-binding debt limits:
 
These proposals do nothing to address the current debt crisis. Essentially, they propose keeping the stable door shut as a solution to the problem of horses having bolted.

Constitutional debt limits are an unwieldy and dangerous way to prevent debt crises. It is possible that Merkel and Sarkozy were so entertained by the recent US debt ceiling drama that they fancied importing it to play soon across a range of different European countries. It is more likely, however, that when debt limits are approached most governments will decide that passing a new higher constitutional debt limit (and taking whatever sanctions Brussels hands out as a result) is preferable to having to instantly cut a deficit to zero.

There is no single number that can be agreed on as representing a sensible ceiling for debt and the imposition of a common ceiling for debt-GDP ratios will likely provoke an outbreak of dubious off-balance sheet accounting and possibly further Greek-style fiddling of official debt statistics.

Whatever future debt-GDP ceiling is agreed, most Eurozone countries will currently be above this level of debt. So constitutional debt limits will need to have phase-in periods, the length of which would likely be negotiated with the European Commission. Ultimately, this will produce a clumsy legal process that won’t have any more credibility than the newly-revamped Stability and Growth Pact. 

Legally-binding deficit rules are also a poor idea:

If passed, they will increase the tendency for pro-cyclical fiscal policy, with spending being cut and tax rates raised during recessions. These rules are a recipe for Europe’s next recession to be even worse than its last.

There are more lessons to be learned from the crisis than simply that countries 'issued too much debt'. The one-size-fits-all monetary policy of the ECB requires well-designed counter-cyclical fiscal policies at national level to ensure macroeconomic stability. It is true that during the good times prior to the financial crises, many Euro area states (such as Ireland) did not run sufficiently large surpluses. However, it does not follow at all from that criticism that Euro area countries should never run deficits, thus limiting the principal macroeconomic tool that their governments still have left to use. 

Saving the Euro?
 
The Sarkozy-Merkel press conference provided the now-obligatory statement that they will 'do whatever it takes' to save the Euro. But what does this really mean? Does saving the Euro require all seventeen members to pass constitutional debt brakes over the next few years? One hardly needs to be an expert on European politics to hazard a guess that these proposals will run into serious problems in a number of Eurozone countries. 
 
The Eurozone is something of a Hotel California construct: Even if a country’s government may feel it was a mistake to join, that doesn’t mean that it is easy to leave. The French and German proposals to require constitutional fiscal policy constraints as a condition of Euro area membership raise the question of how they plan to usher the countries that don’t want these constraints through the Euro’s (currently non-existent) exit door.
 
These proposals also increase the probability that some countries may decide that the price of Euro membership is not worth the hassle, leading to a messy break-up of the Euro area. It may turn out that some of the measures promoted as saving the Euro will be seen by future historians as setting the scene for its demise. It is certainly unlikely that a continent-wide campaign to pass rigid fiscal rules that run counter to textbook macroeconomic principles will do much to boost the Euro’s popularity.
 
Back to the Present
 
The 'Merkozy' proposals have little chance of being agreed and passed by 2012 as proposed. In the meantime, the Eurozone still has a serious debt crisis. Ultimately, there are three possible solutions to the crisis.
 
The first is that fiscal austerity in peripheral countries will convince financial markets that they are worth lending their money to despite the risks of getting 'haircuts' if things go wrong (now an official EU policy). This 'Plan A' approach has not worked so far.
 
The second is a fiscal solution: Either the EFSF is substantially expanded to be big enough to support Spain and Italy or Eurobonds are used to provide new financing. It is this solution that the current proposals are aimed towards. German politicians appear to believe that they cannot sell 'fiscal union' proposals of this type to their public without strong assurances that fiscal profligacy in Eurozone countries is a thing of the past.
 
If this approach really requires a long process of formulating and passing new fiscal rules in all Eurozone member states, then it is not operational now or any time soon. This leaves us with the third solution: Massive ongoing intervention in the sovereign bond market by the ECB.
 
This approach is also unpopular in Germany (and with the ECB’s senior officials). But it can be done without consulting any national parliaments, including the Bundestag. The way is there but is there the will?
 

This content forms part of the E View project, which is part-funded by DG Communication of the European Parliament. 

 


As an independent forum, the Institute does not express any opinions of its own. The views expressed in the article are the sole responsibility of the author.


Comments 1-4 of 4

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The Commission of Ideas says: 21 Aug 2011 12:36

Broadly speaking, I agree with your concerns. The proposed budgetary rules might increase pro-cyclicality. Nevertheless, I think that Germany and France are basically trying to express the same sentiment that is expressed in the Maastricht Treaty: that converging fiscal behavior would create similar economies (with similar monetary needs). Unfortunately, Germany and France were the first two countries to cheat that treaty! In any case, I think that they overlooked trying to converge the financial-regulatory architecture. That would have gone a long way towards preventing the current situation. After reading the BBC article on the matter however, I think that its not all bad. There are also some positive aspects. First of all, a sub-optimal attempt to address the fiscal situation is better than no movement at all on this front. Second, they want a Tobin tax. That would really dampen financial volatility and also make a decent source of revenue.

Shane says: 18 Aug 2011 10:56

The letter sent by Sarkozy and Merkel to Barroso yesterday has been posted online here: http://media.ft.com/cms/1e93f294-c8df-11e0-a2c8-00144feabdc0.pdf

Tomaltach says: 17 Aug 2011 17:17

I largely argee: the proposals will do little to overcome the current crisis. Furthermore, I would agree that a constitutional ceiling on debt is not wise. I think it is wrong, however, to always focus on the negatives. It is easy to underestimate the magnitude of the political problem facing Europe. Down the years national politicians in all countries used the EU as a scapegoat when it suited. Big bad Eu making us cut payments to farmers, enact senseless environmental regulations, and so on. There has never been honest, consistent straight-forward communication with electorates on the pros and cons of European engagement at the big picture or for specific measures. This plus the failure to admit the necessity of deeper political integration as a counterpart to economic integration. The problem here is that the Eu doesn't have the political architecture to deal with this crisis, therefore the initiative has to come from the dominant nation states - Fr and Gr. But here too there are political reasons why some of the obvious solutions are difficult to pursue. It is no secret that there's a lack of statesmanship on the part of these powers, particularly I would say from Germany. The EU solution to this crisis can only evolve slowly because it needs to build a new toolset along the way - indeed it is really trying to modify its constitution as it goes along. This isn't a trivial exercise. Realistically, how can German voters be persuaded to take on Eurobonds? How will Britain react to proposals for further integration, even with opt outs for itself? In the end I do believe Germany and France 'will do whatever it takes' to preserve the Euro - because they have to.

brian t says: 17 Aug 2011 14:49

The "Hotel California" comparison is spot-on. The way I see it: for a country to leave the Eurozone without killing its economy dead, it would have to be on a solid financial footing w.r.t. its EU neighbours. Only that way could they prevent a mass bank run and cash flight out of the country. However, if the country was able to get to that kind of solid state, they probably wouldn't need to consider leaving in the first place. The Euro didn't break countries like Greece & Ireland: it served to expose pre-existing structural problems, and (IMHO) the rest is mere detail!

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