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Tuesday, September 02, 2003

Economist Comes Down on the Side of Reform

The eurozone economies are in the doldrums, and clearly something needs to be done. Essentially, and certainly in the short run, there are only two possibilities: reduce interest rates further, and allow expansionary fiscal policy. The first (which in my view should be done) hits with the Schylla of zone-wide inflation of over 2%, while the latter meets the Charybdis of a zone-wide deficit which is now expected to run at over the limit threshold of 3% this year. The Economist's solution: to reform the pact. Basing itself on a distinction between cyclical and structural, the journal argues (in harmony with recently expressed opinions eminating from the Italian Presidency) that the present pact is ill conceived, as it aims to attack a long term problem with short term objectives. In part this is right (leaving aside for today the fact that it is hopelessly optimistic and naive to hold that the ' pensions problem.........is the result of long-term demographic trends that will take decades to play out and solve". This is going to be played out in the coming decade). There is no point in simply piling on the fiscal pressure over already weary economies. But simply opening the fiscal tap, and reducing rates will not in itself necessarily resolve the problem. Everything depends on what is cyclical and what is trend. It is fine to argue that the "immediate deficit problems are a result of an economic downturn that will correct itself in time". But what if it doesn't? What if I am right, and - as a result of population ageing - trend growth in some of the important EU economies (especially Germany and Italy) is now much lower than many imagine. In this case the short term expediency may not provide the expected traction. If, as is still extremely likely in my book, 2004 sees the German economy facing a deflationary headwind we may well find ourselves with near zero interest rates and rising fiscal deficits stretching Japan-style into the future as far as the eye can see. What will then become of the cyclical structural distinction?

GERMANY and France, so long the European Union’s head partnership, have become partners in crime. Last Friday, Germany confessed to the European Commission that its budget deficit for 2003 would breach the stability and growth pact for the second year running. The pact, a largely German creation, is meant to stop members of the euro area undermining the single currency through fiscal irresponsibility: countries are permitted to run deficits of no more than 3% of GDP. Germany admitted to a deficit of 3.5% last year and expects one of 3.8% this year. Not to be outdone, France on Monday owned up to a projected deficit of 4% this year, to follow a deficit of 3.1% last year. Of the two, Germany was the more repentant sinner. Hans Eichel, the German finance minister, insisted that he was still hoping to abide by the pact next year; Jean-Pierre Raffarin, the French prime minister, has already given up on that goal, according to Les Echos, a French newspaper.

Both governments are likely to breach the stability pact for a third time in 2004. Given that he is campaigning for a €16 billion ($17.4 billion) tax cut next year, Mr Eichel's claims to be trying to trim the 2004 deficit may be no more than the tribute vice pays to virtue. Mr Raffarin, for his part, seems yet to be convinced that deficits in a downturn are a vice or that fiscal austerity at the expense of growth is a virtue. He told the European Commission that his first concern was to find jobs for his countrymen. With French unemployment rising to 9.6% last week, Mr Raffarin's own job probably depends on it. The budget he will unveil in the coming weeks is more likely to answer calls from his own party for tax cuts than to appease the commission’s demands for fiscal restraint.

By 2050, according to simulations by the Organisation for Economic Co-operation and Development (OECD), Germany’s extra pensions spending could add another 2.2% of GDP on average to its annual budgetary burden. If governments add to their debt burdens today, while the baby boomers are still working, they will have less room to borrow in the future to smooth out the cost of the baby boomers’ retirement.

But talk of a pensions crisis only exposes the pact’s longstanding failure to distinguish properly between cyclical and structural factors. France and Germany’s immediate deficit problems are a result of an economic downturn that will correct itself in time. Their pensions problem, which they share with much of the euro area, is the result of long-term demographic trends that will take decades to play out and solve. Last week, for example, Germany’s long-awaited commission on public pensions reform, led by Bert Rürup, unveiled its ambitious proposals for coping with Germany’s greying population. They included postponing the retirement age and reducing pension benefits. But none of the recommendations, even if implemented in full, would bring savings soon enough to mollify the European Commission.

Besides, the pensions crisis will never be solved if the young are not working and the economy is not growing. It seems premature to worry about ageing workers retiring from the labour force, when over 400,000 French men and women under 25 cannot find a way into it. To solve the pensions crisis, European governments need to get more of their citizens into work, postpone their retirements, and raise their productivity. Balancing the budget is only part of the solution.

The stability and growth pact was never really designed to bring about the kind of long-term fiscal consolidation the euro area needs. The pact’s original rationale was to safeguard the credibility of the newborn euro as a hard currency...............monetary policy set by the ECB. Fiscal consolidation would be much less painful if it were accompanied by monetary easing. The problem, of course, is that the ECB must set monetary policy for the euro area as a whole; it cannot lower interest rates in response to one country’s unilateral efforts to repair its finances. Only if the big euro members tighten fiscal policy together will the ECB respond by loosening monetary policy. That is why the euro area needs a pact that is better at co-ordinating budgetary policies than the flawed arrangement in place.
Source: The Economist

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