Dr György Suranyi argues for a new Stability Pact to focus on external accounts and widen the narrowly interpreted fiscal rules.
The euro is a success – despite its governing framework, the Maastricht Treaty and Stability and Growth Pact. Reforming the treaty and pact involves enormous political and economic risks. But not reforming them is even riskier.
The pact should be based on the concept of sustainability, bringing in the external balance as the main criteria for judging a country’s performance. For the 10 new member states of the EU, which are joining the Economic and Monetary Union (EMU) in the not too distant future, the pact in its present form is stricter and even less adequate than for the eurozone member countries, thereby hampering the growth potential in the so-called catching-up period.
The euro is the grand vision of the 21st century. As the common currency of 12, and potentially 25 or so, European states and as a global reserve currency, it is extremely successful. It grew up and matured fast, despite the Maastricht Treaty and the Stability and Growth Pact. Many countries have breached the rules set by these two main pillars of the common currency – and not by chance.
The intention of the euro’s founders was to create a transparent, easily controllable system. But it turned out to be artificial, oversimplified and inconsistent. As a consequence, the growth potential of all of the EU member states is undermined by the strict and narrow interpretation of price and fiscal stability, and the pact as a whole.
Framework contradictions
The biggest contradictions of the policy framework built for the euro are the following. The treaty and the pact concentrate mainly on the numerical aspects of fiscal policy. But macroeconomic policies cannot be assessed without taking into consideration the qualitative aspects of fiscal policy. A fiscal position in itself does not necessarily say anything about the sustainability of that policy. What must also be analysed is the nature – that is the quality – of the policy.
Even a balanced budget may hide bad macroeconomic policies, whereas a 2%, 3% or 4% deficit/gross domestic product (GDP) ratio may reflect justified, well thought-out policies – driven by far-sighted reforms that in the medium and longer term create a basis for a sustainable and increased potential growth rate. Furthermore, the treaty does not deal with the fluctuation of fiscal redistribution in relation to GDP, although it might have at least as much impact on inflation as the changing fiscal balance.
My criticism of the treaty and the pact does not derive from the fact that the interpretation and fiscal rigour is too tight. The main problem is policy related. It is still a mystery why the founding fathers of the euro put an enormous, almost one-sided emphasis on the fiscal side of macroeconomic policy, when what any macro policy is confronted with is the sustainability of the external position (even in the large, relatively closed economies).
Policy formulation
What should be managed are the external accounts. Fiscal, incomes and monetary policy have to create a situation that leads to a sound external position. It is on that basis that macro policies should be formulated. The subject of analysis should be the financing aspect of the external balance. The approach is relatively simple: a current account position (deficit) is sustainable as long as its position is covered by the non-debt type capital inflow in the capital account, for example, foreign direct investment, reinvested profits, EU-transfers, etc.
Any long-term sustainable growth should be based on a solid external position. This external position should set the room for manoeuvre in domestic policies. Domestic policies must take into account traditions: the propensity among households and the business sector to save financial assets. In countries where the propensity to save is traditionally high, the sustainable external position – and the sustainable fiscal position – naturally differs from countries where the propensity to save is traditionally low. Therefore, even inside the eurozone, it is impossible to impose the same simple, numerical rules on different countries. That is why the requirement of balancing the budgets cyclically in the medium term might be contradictory.
A cyclically balanced budget might be too loose, or a cyclically adjusted 3% deficit elsewhere might be fully justified, sustainable and coherent with the overall macroeconomic development.
The US is a good example that supports my view. When the administration of president George W Bush started talking about the necessity of cutting the fiscal deficit recently, it became clear that the current account of the balance of payments had built up an unsustainable position – and not the federal budget. This is the driving force behind the fiscal adjustment in the US, and not the other way around.
In the absence of external pressure, policymakers prefer to avoid crucial decisions. In the US, traditionally low household savings further erode the macroeconomic stability at least as much as the fiscal imbalances and, as a consequence, put at least equal pressure on the external balances.
The German example
Another good example is Germany. Why should Germany go through a painful fiscal adjustment in the short run while its economy – as well as the eurozone – is running a current account surplus? The current account surplus reflects the lack of adequate domestic demand in Germany. And the lack of domestic demand is a reflection of the low level of consumer and business confidence. If the situation is handled only through fiscal measures, it might lead to a further contraction in the German economy.
The so-called excessive deficit in Germany (above 3% of GDP) has not created an excessive demand. On the contrary, it offsets the lack of demand. The solution is not to relax the fiscal policy further, but to find a way to regain consumer and business confidence. While it is up in the air, partly because of the long delayed and much needed painful structural reforms, the answer is definitely not the one-sided fiscal adjustment.
I would not see any major problems arising in the medium and longer term with the same budget deficit, if it was fuelled by the effects of labour market liberalisation, deregulation and tax reform. Only deep-rooted reforms would accelerate the German economy to fulfil its growth potential and reduce the fiscal deficit. Unfortunately, it might have a negative short-term fiscal impact.
For the new EMU-accessing countries, and especially the central and eastern European (CEE) euro applicants, the implementation of the treaty and the pact is even more contradictory. Their potential growth rates are significantly higher than those of the core eurozone countries. The optimum rate of inflation is necessarily somewhat higher as well. Applying the artificial rules of the treaty and the pact would undermine their potential growth rates. As their potential growth rate is higher, productivity is improving at a higher speed as well, so their currencies will appreciate in real terms. Under these circumstances, there is no way to fulfil the exchange rate stability criteria and the inflation criteria simultaneously. (Paradoxically, due to the credibility or the lack of credibility of the candidate countries’ macro policies, the markets might bring these countries unilaterally into the eurozone much earlier than the target date set in the convergence programme.)
A further contradiction is that, while the potential nominal growth rate in the CEE countries fluctuates between 7% and 9% (meaning a real potential growth rate of 4% plus Consumer Price Index 1%-2% above the eurozone), the developed EMU economies’ potential nominal growth rate is 4.5% (2.5% real growth rate plus the maximum 2% inflation). If we accept that the sustainable fiscal condition is based on the criteria that the GDP/debt ratio is not allowed to exceed the 60% limit (although that number is not supported by economic research and could be 50%-70%), then the maximum tolerable fiscal deficit is 4%-5% annually in the CEE countries. So, the same nominal criterion is stricter when applied to the accession countries.
These states do not have a blank cheque, though, to fill the gap between the 3% deficit (or cyclically balanced budget) requirement and the higher deficit level deduced from their higher rate of growth and inflation. For example, in Hungary, where domestic household savings dropped to zero, the tolerable fiscal position must be even tighter than those that the Stability Pact currently requires in the eurozone. Because the savings ratio is so low, the current account deficit of past years is not sustainable in the long term.
New considerations
I am not arguing for loosening the pact or making the rules more flexible. My point is to take other factors into consideration as well. First, without analysing the quality of the macroeconomic policy of a given country, we cannot and should not draw a conclusion on that policy. Second, we cannot apply the same numerical rules in different countries, in different time horizons. Third, instead of placing the narrowly interpreted fiscal rules at the centre of attention, we must focus on the sustainability of the external accounts. That is where governments have to face the markets, and markets will push governments to put their fiscal houses in order.
Dr György Suranyi is a former president of the National Bank of Hungary and is now on the board of Banca Intesa, among others
