Europe: a child of the economy, an orphan of politics

Jean-Paul Fitoussi

As we move towards the future, the situation is bleak. The decisions made at successive European summits do not seem likely to address the structural defects of the Eurozone. The disappointment with the Europe of today is that it deals with a constitutional problem as if it were merely an economic one. The fiction of the sustainability of Europe, a child of the economy, but an orphan of politics, continues to undermine European integration.

It is certainly true that the proposed banking union shows real progress. But only part of the union’s supervision has been defined, and it comes into force in 2014. Its other elements - the resolution of banking crises and deposit insurance - remain under national jurisdiction, and their European future is even more uncertain. There must be real solidarity, something which Europe lacks most of all.

We have the Growth Pact and the Treaty on Stability, Coordination, and Governance. To which future are they leading us?

As it was signed, the Growth Pact – investment projects financed primarily by existing structural funds and the European Investment Bank’s increased capital (10 billion Euros) – is not likely to transform activity in the Eurozone. We are talking about 120 billion Euros; even this is mobilising funds which have not yet been used, to enable the EIB to lend 60 billion Euros by leveraging its capital increase. Whether or not a start has been made is a mystery. This is why the European recovery seems more symbolic than real, a remake of the addition (fiercely negotiated in 1997) of the words "and growth" to the Stability Pact. Because, at the moment, EU regulations and conditions for assistance to countries considered fragile have plunged these countries into depression and have delayed Eurozone recovery. Have we really helped Greece, given that its GDP is currently more than 20% lower than it was on the 1st January 2008?

It is difficult not to view the Growth Pact as the soothing balm applied to smooth the roughness of the "fiscal compact." Therefore, we have a treaty which establishes the fiscal solitude of each of the Eurozone member states through a promise of greater solidarity if they show themselves to be capable of solving their own problems. It forces, or rather, it requires states to self-impose sanctions or risk facing penalties, to have fiscal rules that are found in no other democracy in the world. In fact, it aggravates the European democratic deficit, making member states even more federal, and, at the same time, even more the orphans of a federation.

 

Rules and choice revisited

Since the end of World War II, economists have been debating the question of whether to emphasise rules or discretion in economic policy. In the forties, Milton Friedman had already advocated adopting monetary rules and suggested enshrining balanced fiscal rules in the constitution. But it was the "revolution" of rational expectations and the neo-classical school which established in a "definitive" way the superiority of rules over choice[1]. Much attention was given to this conclusion, which inspired monetary policy management in many countries. But no country gave up its fiscal sovereignty, or indeed its monetary sovereignty, since in all countries (except in Europe) central banks are accountable to national parliaments. The neo-classical school’s demonstration would only apply to a world without imbalance, where economic policy resembled Don Quixote’s fight.

But how was Europe, probably without knowing it, able to endorse such a doctrine?

The reason is that adopting this doctrine binds governments’ hands so strongly it prevents them from acting, even in circumstances like today where inaction is irresponsible. Social suffering worsens, unemployment soars, recession threatens the Eurozone and depression takes hold in many countries. Can we then do nothing to fight against these ills and against budget deficit reduction as the sole macroeconomic policy?

It is true that distrust of democracy occasionally leads to fiscal virtue in some countries. In 2011 in the United States, for example, the Republicans tried to pass a constitutional regulation in Congress to have a balanced budget. But great voices were heard and the attempt failed.

In a letter addressed to President Obama, the President of Congress, leaders of minorities and majorities in the House of Representatives and the Senate, with eight of the greatest economists of our time[2], urged Congress to reject the amendment to introduce into the constitution a balanced budget clause. Their arguments are very widely shared by the economic community. The principles are worth returning to.

1 - Preventing automatic stabilisers from working aggravates recessions.
2 - It is legitimate, as it is for other economic actors, to allow the state to finance investment expenditure by borrowing and thus have a budget deficit.
3 - Such an amendment would encourage Congress to pass on to local authorities (who do not have the means) the finance expenditure that it is not in a position to take on. It will also prompt creative accounting with the selling of, for example, public assets. It will be left to judges to interpret the country's fiscal situation, which could lead to an economic policy defined by the courts.
4 - Nowadays, it is dangerous to try to balance the budget too quickly. The very substantial spending cuts or tax increases that would be required would be very detrimental to a recovery which is still uncertain.

These arguments are good theory and can also be applied to the Treaty on Stability, Coordination and Governance.

All the arguments put forward by the American economists in their letter to President Obama apply to European rules. Of course it could be said that the treaty looks at the structural deficit and not the nominal deficit and, therefore, does not prevent the automatic stabilisers from working. But as it requires member states to define and apply a convergence path from now on, and furthermore it forces countries to reduce by one-twentieth per year the gap between their actual debt and that tolerated by the Stability Pact (60% of GDP), it at least partially blocks the automatic stabilisers. This is another way of saying that it obliges countries to bring forward, taking into account the current situation, a pro-cyclical policy which is restrictive in a period of recession.

It puts the Court of Justice at the centre of the measures, as the economists mentioned above feared it would. Furthermore it stipulates that member states establish an independent national institution to monitor the Treaty’s enforcement. Lastly, it requires countries with deficits considered to be excessive to implement a "partnership" programme under the supervision of the European institutions. There is evidence of a reduction in the fiscal role of parliament, which is putting democracy under technocratic guardianship. Instead of being under the guardianship of an unquestionably legitimate federal state, they are put under the control of independent institutions with weak democratic legitimacy.

In the absence of an agreement to "fix" the European Constitution – making the ECB a fully functional central bank, pooling debt to make market arbitration impossible, just as the single currency (the pooling of currencies) put an end to speculation on intra-European exchange rates. European states are also obliged, under the current Treaties, to reduce debt. This is where fears of a long European recession find their roots.

Are we doomed to repeat the same mistakes? In 1929, the day after the crisis, the British government published a white paper, known as the Treasury view, to essentially say that public investment policy would have no effect except to damage the state finances, and that overall maintaining a balanced budget was the wisest policy. This doctrine was applied not only in England but also in Germany and the United States (until the New Deal). So the question up for debate focused on ways to combat unemployment and public investment that were advocated by some economists. Richard Kahn, before Keynes, invented the concept of the employment multiplier[3]. But the Treasury view said that the increase in public spending could affect neither activity nor employment. The theory was based on the crowding-out effect: such an increase would result in a decrease of equal magnitude in private spending, so that domestic production could not increase. This tipping effect assumes that there is either a physical limit to production increases – production capacity would be saturated – or higher public investment would lead to an increase in interest rates[4] which discourages private investment. This theory is based on Say's law, known as the law of markets[5]: "supply creates its own demand." In other words, there would be no problem with the markets, and it would be futile to try to increase the demand to revive the economy. Only action at the supply level would lead to such a result. It is understood that Keynes made ​​this law his worst enemy. But we can understand why the Treasury view precipitated depression because we know what happened.

Eight decades later, Europe has the same opinion – not only that salvation will not come from a public investment push, but also that public spending should be reduced and taxes increased to create conditions for future recovery. So much for global demand! Instead it is a policy of supply that must be pushed forward. The hullabaloo over the issue of competitiveness originates from this decree. The Gallois report in France, and the competitiveness plan that ensued, demonstrate this. The competitive shock from which a miracle is expected results in transferring, say, twenty billion euros from households to firms. The purchasing power of the former and the labour costs of the latter will be reduced accordingly. French companies would thus become more competitive, but it is not the (flagging) French demand from which they can expect extra markets, but foreign demand, especially European. Yet the internal demands of other European countries are sluggish, as they all pursue the same policy with everyone looking to increase their competitiveness. The surest outcome of these overlapping strategies is a collapse in demand, and yet these are the only strategies authorised by the European rules. What can a government forced to cut its spending and raise taxes (without devaluing its currency) usefully do to boost growth? We find, in this context, the same ingredients that led to the deepening of the Great Depression of the thirties: competitive devaluation first, then trade wars and protectionism. There is a strange similarity between the treasury view back then and the doctrine that led to the fiscal compact of today.

Fortunately, this time, the circle of madness is limited to Europe. Other parts of the world seem to have learned the lessons of the Great Depression of the thirties. It is fortunate too that the power of conventional ideas seems to involve more than just fiscal policy. Central banks have learned a lot and are ready to drive forward the most heterodox strategies to safeguard the future. But will the European treaties leave the ECB alone? And will governments resign themselves to a lost decade of growth, more than half of which has already passed?




[1] See F.E. Kydland & E. Prescott (1977) : “Rules rather than discretion: the inconsistency of optimal plans”, Journal of political economy, Vol. 85, No. 3. and R.E. Lucas (1981): “Rules, discretion and the role of the economic advisor”, in R.E. Lucas : Studies in Business cycle Theory, The MIT Press.

[2] Kenneth Arrow (Nobel prize), Allan Blinder (Former Vice-President of the Fed), Peter Diamond (Nobel prize), Eric Maskin (Nobel prize), William Sharpe (Nobel prize), Robert Solow (Nobel prize), Charles Schultze (Former President of the Council of Economic Advisors) and Laura Tyson (Former President of the Council of Economic Advisors). http://www.cbpp.org/cms/index.cfm?fa=view&id=3543

[3] "The Relation of Home Investment to Unemployment", 1931, Economic Journal.

[4] The state has to borrow to finance investment, the demand for credit increases and therefore so too do interest rates.

[5] Or at least a simplistic interpretation of this law, see Robert W. Clower: “Trashing J.B. Say: The Story of a Mare’s Nest” in K. Vela Velupillai: Macroeconomic Theory and Economic Policy, Essays in honour of Jean-Paul Fitoussi, Routledge, 2004.