09 April 2012

Martin Feldstein: Europe needs the bond vigilantes

Spain's disappointing government bond auction is a sign of things to come, writes Feldstein in the WSJ. If Europe's debt-bound governments won't get their fiscal houses in order, the bond vigilantes will descend, pressuring them to do so.

Europe's heads of state, however, still seem to think the solution is greater political unity not individual fiscal discipline. Indeed, 25 eurozone governments are now engaged in ratifying a "fiscal compact". Its stated purpose is to prevent a repeat of the explosive increase of sovereign debts that can still threaten the solvency of those nations.

Sadly, there are so many weaknesses in the treaty that it will not be any more successful at preventing large budget deficits than the earlier Stability and Growth Pact that was quickly abandoned after its rules were violated by France and Germany.

According to the treaty, every participating country must limit its "cyclically adjusted" budget deficit to no more than 0.5 per cent of its GDP and must run fiscal surpluses until its debt is down to 60 per cent of its GDP. Compliance with these limits will be judged by the European Court of Justice and fines imposed on countries in violation.

But what would it mean in practice? How would the critical "cyclically adjusted" deficit be measured? Consider Spain with a current unemployment rate of 23 per cent, nearly double its level a few years ago. How much of its 6 per cent budget deficit is cyclical? Spain could argue that its entire deficit is now due to its cyclical weakness and that it therefore has no cyclically adjusted deficit. Could a court really impose a fine based on rejecting this very ambiguous calculation?

With a current debt of 160 per cent of GDP Italy should, according to the treaty, have a budget surplus of 5 per cent of GDP if growth is stagnant and even more if it's declining. That much austerity would create a massive economic downturn, raising its deficit and debt. That makes no economic sense.

The treaty says that the deficit is to be measured "net of one-off and temporary measures". Wouldn't a countercyclical stimulus programme of road building and cash transfers be considered to be one-off? Couldn't any public construction programme at any time be called "one-off"? Shouldn't any government programme that is not permanent be called "one off"?

There is no reference to state-owned enterprises. Are debt-financed investments by state-owned public utilities to be counted as part of the fiscal deficit? They certainly wouldn't be if the same enterprise were privately owned. And where is the line to be drawn between public utilities and health-care facilities like public hospitals?

There is also no mention of the effect on the deficit of changes in nominal interest rates. With current debt levels, a one or two percentage point rise in the interest rate on government debt caused by a fear of future inflation would significantly raise current fiscal deficits.

The treaty will come into effect if just 12 of the 27 European Union countries ratify it, a low-enough hurdle to make its adoption virtually certain. Political leaders will claim that this is a major milestone en route to European political union. But it is really an empty gesture that will have no effect on future deficits and debts. Fortunately, the bond vigilantes understand this and are on the job.

Full article (WSJ subscription required)

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