The EU Fiscal Rules: Not Fit for Purpose

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aus_treatyWhat would you say about a system for your car that was sold on the basis that it would alert you to an upcoming crash?  A good idea, no?  Except that the system only warns you after the crash.  There you are, in a massive, multi-car pile-up, bleeding all over the M50 – and only then does the system kick in:

‘Warning, warning, you are an imminent danger of having been in a crash – warning, warning.’

You’d be right to sue.

That’s how the EU fiscal rules operate:  it purports to provide an early warning system against economic crash but, in fact, it does no such thing.  We should return it to the manufacturer, unopened, postage due.

Remember the Fiscal Treaty campaign?  It was claimed by the proponents that we needed these rules because it would prevent things like the Great Recession and, in particular, the Irish crash of 2008.  We needed these rules because we Irish are irresponsible – along with the other PIGS states.  If only we had these rules we could have escaped the crash, the debt crisis and the recession – which was, of course, brought on by our fiscal irresponsibility.  That was the narrative.

But the cold reality is that were these EU fiscal rules in active operation they would not have seen, predicted, never mind warned of the impending crisis.  It would have been as useful as a diviners’ rod.  How can we know this?  Because the EU Commission, the fairground purveyor of these miracle rules, tells us so.

The rules focus on the structural deficit.  This measures the deficit when all the cyclical components are stripped out – that is, all the boom and the bust parts of the economy.  It purports to tell us what the deficit would look like if the economy were on an even keel.

If so, then the EU rules should have been blaring warning sounds with red lights and sirens in Ireland in the years before the crash.  Everyone knew (if only in private) that during the period of 2000 – 2006 Irish public finances were dangerously over-reliant on revenue from the speculative boom.  Everyone – except the EU Commission and their rules.

Let’s look at the estimate from the EU Commission itself.  Remember:  if the figure is in plus, that means we were fiscally responsible, our public finances were robust, and we were almost German-like when it came to prudent budgeting.

sd1

 

Oh, my:  according the EU rules and methodology we had extremely sound public finances.  In every year, we were in surplus with the exception of the two years surrounding the temporary global slump following 9/11.  In reality, our public finances were going off the rails during this period – but the EU rules, instead, insisted that we were in fiscal clover.

It gets better.

aasd2

The EU Commission rated Ireland’s public finances as one of the best in the Eurozone.  Only Finland and Luxembourg had healthier public finances.  The Irish structural deficit was, on average, in surplus.  However, most other countries, including Germany, were going through some pretty ‘irresponsible’ and ‘profligate’ times.  The Eurozone was in chronic deficit.

So when did the EU rules give Ireland any ‘warning’?  After we started bleeding all over the M50. .  In 2006, the structural deficit was in surplus. By 2008, the Irish structural deficit collapsed to-7.5 percent – after the crash started.   Did the Government change policy in these two years?  No.  They were doing the same ol’, same ol’.  It’s just that the early warning system didn’t work.

If you think this is some left-wing, trade union-y rant against reasonable rules designed to turn us into prudent European citizens, you might want to consider this.  The Irish Fiscal Advisory Council was before the Joint Committee on Finance, Public Expenditure and Reform last Thursday.  In response to a series of questions put by Richard Boyd-Barrett TD, the chair of the Fiscal Council – Professor John McHale – had this to say about the structural deficit:

‘In the run-up to the crisis, the measures of the structural deficit and associated measures of the output gap were extremely poor. In retrospect, we know that we were in an unsustainable situation with the economy operating well above its sustainable projection and the measures of the output gap did not pick that up at the time . . . they essentially gave us nonsense measures of the structural deficit.’

‘Extremely poor’.  ‘Nonsense measures’.  Both the tone and content of Professor McHale’s remarks show an appropriate level of disdain.

Why are the rules so poor?  Two quick reasons (there are more).  First, the structural deficit is a hypothetical measurement.  It is not observable in the real world, unlike the nominal deficit which just counts how much revenue you take in and spending that goes out.  Worse, the structural deficit is built on layers of other hypothetical measurements:  output gap, potential GDP, total factor productivity, and the talk of the local pub:  the non-accelerating inflation rate of unemployment.  The potential for nonsense results increase as the layers of hypothetical measurements mount.

A second reason for the poor construction of the rules is that it doesn’t take into account private debt – which caused the Great Recession.  In many economic models, private debt is not included because it is assumed that it cancels out.  In a debt transaction, assets = liabilities (i.e. I owe you €100 and you are owed €100 by me – we cancel each other out).  There is an underlying ideology to this – the efficient market hypothesis assumes that the price of assets/liabilities is equal to the value of assets/liabilities.  Ask anyone in arrears:  is the price of their mortgage equal to the value of their home?  You see the problem.

Who in their right mind believes that this pottage is a robust way to regulated public finances?  And who in their right mind would campaign to have this pottage inserted into our Constitution?  Oh, I forgot:  Fine Gael, Labour, Fianna Fail, etc.

But we are stuck with these rules – for the time being.  Fortunately, more and more countries are finding ways out of them.  Our own government negotiated a temporary derogation from these rules for next year; otherwise, it wouldn’t have up to €1.5 billion to cut taxes and increase expenditure (if the rules were strictly applied, we’d have nothing).  By the end of the decade these rules will morph into something quite different – but whether that ‘different’ will be better than what we have now is another question.

A progressive government would do a number of things:  it would push these rules out at every opportunity (there’s always space in the footnotes if one is creative); it would campaign throughout the Eurozone showing the ‘nonsense’ of these not-fit-for-purpose rules; and it would create alliances with other governments which are also coming under irrational pressure to abide by rules which do not suit their economies and societies.

One thing’s for sure:  if we persist with these rules over the long-term we will have a warning system in our fiscal car that doesn’t work.  And we will be paying for that warning system by starving our economy.

Not a great exchange.

 

Image: A Socialist Party Anti Fiscal Compact Treaty campaign poster courtesy of Irish Election Literature

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