Euro Pills: How (Not) to Save Europe

The Commission’s proposals for fixing the Euro mess are numerous and involve many economic and legal problems. As for the latter, the trade-off is between timeliness and effectiveness of the measures. More ambitious reforms require amendments of the European treaties and therefore run the risk of being mired in exhausting legal battles. I summarize below the main economic proposals, and my opinion in pills, referring the interested reader to links with more in-depth discussions.

1. Strengthen fiscal discipline by lowering the threshold for excessive deficits from 3 to 0.5% of GDP
Bad idea. The problems in Europe, with the exception of Greece, do not come from excessive deficits. They arise from non-convergence of productivity growth rates and in a widening competitiveness gap between “North” and “South”. Excessive deficits are the result of the international recession. The problem of the ineffectiveness of the EU budgetary discipline is not due to the fact that the 3% deficit/GDP limit is too high, nor to the low credibility of the sanctions (which Germany and France have contributed to weaken with their proposals in 2006). Reducing the deficit limit will result in a deflationary bias at the EU level. The problem is how to introduce incentives for debt reduction for countries in cyclical expansion, such that they have the possibility of running deficits in recessions, while not incurring in a secular increase of the debt ratio. I have presented (at the  European Parliament) a proposal similar to the “points” scheme for a driving license, that you earn with good behavior (budget surpluses)  and you spend  with bad behavior (deficits), see here and here

2. Automatic sanctions
Good idea. You could think of automatic penalties both in terms of fines, for example a reduction of EU funds in proportion to the deviation or in terms of political sanctions, including the suspension of voting rights. The important thing is that these penalties should apply to state contingent (for example, they should refer to cyclically adjusted balances, see above)

3. Introduction of the balanced budget rules in the Constitution of the EZ countries
Bad idea
. On the one hand the condition of a balanced budget is neither sufficient nor necessary to ensure debt sustainability. On the other hand, the experience with fiscal rules suggests certain skepticism about the effectiveness of these rules: in general it is the virtuous countries that put these rules in its constitution, the rules are not to make virtuous countries (see here). The explicit criterion that annual fiscal adjustment should occur in proportion (1/20) to the deviation of the debt ratio from the 60% objective is quite dangerous and would impart a further recession bias to the EZ (see here)

4. The possibility for the European Court of Justice to challenge the National Budget laws
Bad idea. This is a surreptitious way to force the countries of the Euro zone to give up part of their national sovereignty. It’s likely to be ineffective and to produce a conundrum of legal battles.  There are no shortcuts: it is necessary to amend the Treaties, so that over time national Parliament devolves some powers to a European federal budget. My proposal is to adopt a two-step budget process. In the first the European Commission, say, decides on the budget balances of the EZ members States, and in the second the national parliaments choose the level and composition of revenues and expenditures under the constraint established at the European level. I discuss in this interview with  Voxeu .

5. Anticipating the entry of the ESM
It does not solve the problems. The ESM, which is the successor of the EFSF, suffers from a series of faults that this proposal does not addresses:  a) the size of its budget is insufficient (despite proposals to give the EFSF the ability to provide partial insurance to new bond issues, or to introduce the possibility of securitization) b) the funding mechanism of ESM could propagate the crisis to countries in difficulty, c) the voting rules make the local ESM hostage to tiny minorities. Here the Commission allows for a qualified majority of 85% replacing unanimity in case of emergency. Useful, but possibly not sufficient. d) The previous arrangements for PSI had the effect of discouraging private investors by making current debt issues junior in the case of restructuring (see here). The new rules now simply refer to consolidated IMF practice .