The economics of the summit: an expensive signal to the ECB

After the publication of the euro summit’s conclusions on Friday, I have been asked by a number of journalists whether the new treaty would be ‘successful’. My reply was that you needed to define ‘success’ before you could answer the question. While some of the journalists were struggling to give me a good definition, it struck me that there were people left who actually thought the treaty change was about economic or fiscal logic.

The truth is that the whole ‘fiscal compact’ was never about impressing the markets or even instituting a sensible economic governance framework for the euro area. It was about getting the ECB into a position from which it could start large-scale support of the bond markets for euro periphery sovereign debt. As both ECB and Bundesbank officials have been afraid of countries such as Italy or Spain exploiting any ECB interventions in the bond markets and as a result slowing down their reform efforts, this only could be done by an extra dose of fiscal austerity.

By itself, the new compact from its very design was unlikely to impress financial markets on a sustained basis. Materially, the compact is little more than what has already been in the ‘six-pack’ on the recently decided reform of economic governance mechanisms. The only new element is the provision that all countries write a ‘golden rule’ similar to the German ‘debt brake’ into their constitutions, limiting structural government deficits to 0.5% of GDP. While the level of commitment here might have been new, the stability and growth pact’s provision to aim at a budget ‘close to balance’ in the medium term is little else than this golden rule.

In short, the provisions are now:

–          Automatic sanctions if a country exceeds the 3% deficit-to-GDP limit of the Maastricht treaty (which can be stopped with a qualified majority)

–          In addition, countries which a debt-to-GDP ratio of more than 60% need to reduce this ratio by 1/20 per year

–          The European Court of Justice can rule on the legality of national budgets

–          Each country will include in its laws (and preferably into its constitution) a ‘golden rule’ limiting structural budget deficits to 0.5% of GDP.

Formally, if these rules are complied with, solvency of member states should not be an issue anymore. So, why are financial markets not impressed? The answer is that investors by now do not necessarily doubt the will of periphery government to cut budget deficits. They are rather spooked by the absence of economic growth and the danger that capital flight from the periphery pushes interest rates there to levels which countries cannot bear anymore. And the new rules are not easing any of these problems.

For economic growth, the new compact will be toxic. Especially countries with high debt-to-GDP ratios will now have to cut budget deficits more quickly and more brutally – even though the current level of fiscal restraint is already far beyond the point which one can do without doing large damage to the economy. Take Italy: With a current debt-to-GDP level of almost 130%, according to the 1/20 rule, it needs to bring down this ratio by 3.5 percentage points a year (130 minus 60 divided by 20). For 2012, the OECD sees Italian GDP nominal growth at 1.3% (which in real terms means a minus of about 0.5%). For 2013, the OECD expects a slight pick-up of nominal growth to 1.7%. Under such a growth environment, Italy would need a budget surplus of almost 2% of GDP to fulfill the 1/20 rule. For comparison: The OECD projects Italy’s budget deficit for 2012 at 1.6%. The 1/20 rule thus requires another 3.6% of GDP in additional budget cuts for Italy on top of the brutal austerity measures already planned.

Investors are right to doubt the success of such an austerity strategy. This is not about the willingness of governments to take sacrifices anymore. It is about the question of how deep a recession a society can bear and whether a new European treaty can defy macroeconomic logic. What has been learned in past economic crisis is that even if you make laws prohibiting one thing or constitutions prescribing others, in the end economics trumps legal provisions. In Argentina, the deep recession in the 2001/2 crisis swept away the convertibility law and a handful of governments in close succession. In Europe, an unrealistic decade long austerity path might topple governments and in the end even European treaties.

Moreover, from an economic governance perspective, this compact will not be able to prevent a crisis such as the one we are seeing now. At least for Ireland and Spain (two important crisis countries), the problem was not governments running excessive deficits because they were overspending. The story was giant real estate and financial bubbles bursting and dragging the national economies into recession, which in turn wrecked the public budgets (which had actually been in surplus in Ireland and Spain prior to the crisis). It is very unlikely that fiscal sanctions or tighter rules on debt reduction would have prevented the spread of red ink in these cases. Or do we really believe that the threat of a fine of the magnitude of a couple of percent of GDP would have prevented the Irish government from stabilising their banking system?

Following this analysis, it is unrealistic to expect investors to return in droves to euro periphery countries anytime soon. So no help for beleaguered countries from the financial markets either.

Given this gloomy outlook, in how far can the summit be called a success? At least it might have opened a door for the ECB. The central bank’s president, Mario Draghi, has already welcomed the compact. Possibly, this is a signal that the new rules will satisfy the ECB enough to actually step up to its role as lender-of-last-resort and end the liquidity crisis of euro area governments. This might be a success as it could at least end the current downward spiral towards a break-up of the euro area in the coming months, and might secure access to financial markets by the crisis countries.

However, even if the ECB now will show the courage to act in a constructive way, the new treaty means very low economic growth in the euro area for at least half a decade. This will not only make long-term sustainability of debt a reoccurring issue over the coming years, it will also increase social and political tensions in the euro countries and diminish Europe’s foreign policy leverage globally.

Add the rift over Britain’s role in the EU, and the new treaty certainly bears a very high price for the German ideology of a central bank not acting as a lender-of-last-resort for governments. Unfortunately, it is not only the Germans who hold this ideology dear who have to pay: the whole euro area now has to pick up the tab.