Fiscal Discipline Alone is not Enough

By: Adam Posen

The reform of euro area economic governance will ultimately have to include greater systemic fiscal transfers and stabilization, not just increased budget discipline.  The anger over Greek deception and the fear of a sovereign debt crisis may make fiscal discipline prominent among some euro area decision-makers.  But such one-sided reform will have costs that will become even more evident in the next couple of years.  It also ignores a key source of the current crisis, the lack of sufficient counter-cyclical stabilization within the euro’s monetary union.

 

In a paper I wrote for the euro’s fifth anniversary, I made two points[1]: that the limits on counter-cyclical fiscal policy in the euro area were surprisingly binding; and that the longer-term interest rate declines induced by euro membership for some countries did little in real terms to make up for the loss of fiscal stabilization.  This is consistent with the fact that it was (mostly earlier) real economic integration, not monetary union, which provided the euro area members with productivity gains, even though EMU delivered price stability and lower government interest rates.  

 

So this implies that the lack of macroeconomic stabilizers - monetary or fiscal - for divergent economies in the euro area is a major cost, one which became huge in the face of the shocks from the global financial crisis.  And while Greece obviously is in a trap of its own making, Spain and Ireland among others are not, at least not primarily.  Put differently, some of the fiscal erosion and deficits, as well as of the bad economic outcomes, were due to the divergences inside the confines of the euro area, not due to lack of fiscal discipline - especially since interest rate declines did not produce the structural or productivity gains that were hoped for advocates of that fiscal discipline.

 

If what emerges from this crisis will be greater SGP teeth and penalties, unaccompanied by greater fiscal stabilization and transfers, then average euro area economic performance will suffer further.  Yes, the idea is to aim for truly counter-cyclical fiscal policies, with budget surpluses in the good times allowing fiscal ease in the bad times.  But this will be preceded by additional fiscal contraction in the next couple of years during a weak recovery or double-dip in the euro area.  The limits on the SGP are already too tight for this stabilization, and unfortunately that is what will be tightened rather than fundamental fiscal reform..

 

Meanwhile, the hue and cry about the ECB announcement that it will buy bonds is as misguided.  What the ECB is doing is not monetary easing.  They are reducing intra-euro zone interest rate spreads de facto by buying bonds of periphery countries with high interest rates and creating liabilities or selling bonds of the core economies.  This is a fiscal transfer by means of cross-subsidizing interest rates off government balance sheets.  If it has any monetary effect, it will result in a rise in euro core interest rates, not a loosening of credit conditions, let alone inflation. The main point is that there will not be more activist ECB stabilization of output swings – and such an effort would do little to smooth out divergences, which requires fiscal policy.

 

 

For the time being, most developed economies, and certainly the peripheral euro members have no choice but to engage in fiscal consolidation.  That is necessary to avoid a jump in interest rates on government borrowing in the current situation.  And yes, having too large a share of the state in the economy can be harmful.  There is no correlation, however, between keeping the size of debt and of the state below some limit and restricting counter-cyclical fiscal measures, especially automatic stabilizers.  The current need for consolidation is not a lasting argument against the virtues of properly structured stabilization policy.

 

Bottom line, though obviously fiscal irresponsibility as in Greece has costs, increasing fiscal stringency in euro governance without improving counter-cyclical stabilization and limiting divergences over the long-run will make matters worse.  Fiscal transfers within the euro area, perhaps building on the IMF's useful initiative, would be a way of improving matters. In a diverse monetary union, the direct economic benefits in terms of credibility for peripheral countries of binding government’s hands are insufficient alone to make up for the loss of counter-cyclical policy.  It is in the monetary union’s interest to reduce divergences or better offset nation-specific shocks, and full fiscal reform can achieve that. One dimensional focus on fiscal discipline will not.

 

Adam S. Posen is senior fellow at the Peterson Institute for International Economics in Washington, DC.

 

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