Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 31 January 2012

EU Fiscal Compact - An economic straitjacket


The fiscal pact has been signed and the markets and pundits cheer. Hurrah!
British Eurosceptics thankfully stopped David Cameron from compounding Gordon Brown's Lisbon treaty disaster. And Czech Republic had the good sense to stay away from this economic straitjacket. This is a treaty which has been signed in haste and will be repented at leisure.

So what is this treaty, what does it achieve and is it indeed positive?

Briefly, according to the Eurozone leadership, this treaty will prevent another debt crisis. Excellent. My house is burning down in front of my eyes so what I must do is call up a guy to install smoke alarms and paint the walls with fire retardant. But let us take these claims seriously because if Draghi starts spraying with his hose then the fire will be put out immediately (water damage is a separate issue).

The treaty enshrines the Maastricht criteria into the national constitutions of the signatories. The main points being:
1. Structural budget deficits cannot exceed 0.5% of GDP.
2. Automatic correction mechanism for countries whose deficits exceed 0.5% significantly (Maastricht limit on deficits was 3%)
3. These countries will have to submit their national budgets to the European Commission (EC) for approval (No, no viceroy will be appointed to administer the hitherto sovereign nation). And they will have to get within the limit within a prescribed time period.
4. If the debt-GDP ratio goes above 60% (Maastricht ceiling), it would have to be reduced by 0.5% per annum.
5. In case of non-compliance to EC's directives to get their house in order, the European Court of Justice has the power to to make countries comply and impose fines upto 0.1% of GDP.

The treaty will enter into force on 1st January 2013.

The treaty imposes very strict and onerous conditions on the signatories. It substantially removes fiscal sovereignity. As monetary sovereignity has already been ceded to the ECB, it means that EU nations have effectively lost control of economic policy to some mandarin in Brussels.

Proponents may argue that the five points above may look draconian but will be implemented wisely and pragmatically (Wise and pragmatic - the two qualities consistently hidden from the public in the handling of this crisis). The automatic correction mechanism is only triggered for significant observed deviations from 0.5%. Therefore a country can easily run a expansionary fiscal policy to combat recession in the short term. This is a sophist argument. First, if the loophole is this large then the treaty will be cast aside like the Maastricht criteria by the politicians. One only needs to look at Gordon Brown's constant shifting of the goalposts to justify all his budget deficits to understand this. If it has teeth then capping deficits at 0.5% of GDP is arbitrary and excessively restrictive. In a recession, the automatic stabilisers (unemployment benefits, etc) combined with a fall in tax revenue will ensure that the deficit crosses this figure unless the government embarks on an austerity drive. Thus the treaty ensures that when the private sector is cutting jobs, the government most likely will as well.

The cap on debt-GDP at 60% is an act of bolting the barn door after the horse has bolted. Reduction to this level is going to be counter-productive at this stage. In conjunction with the cap on deficits, what this means is that signatory states will have to run budget surpluses for the foreseeable future. Once again the austerity led growth argument is being assumed as a truism in spite of evidence to the contrary.

The other problem being glossed over is the loss of national sovereignity. At the moment, with the market's gun on their head, politicians and the public are happy to cede powers to the EU/EC/ECJ. However what happens if a future recession is confined to a few EU states? Will they tolerate a job-killing austerity drive dictated by the EU? (Actually this is purely hypothetical since with current policies there is no future to speak of)

Therefore there is little to cheer from this fiscal treaty. The markets seem to realise it as EURUSD is back down, DAX has fallen back and Bund futures are back up towards close. The treaty is a non-event from a trading point of view. And it leaves the investment thesis for Europe unchanged.

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