Friday, January 30, 2009

Growth and Stupidity (stability) Pact

The growth and stability pact states members of the Eurozone should not borrow more than 3% of GDP. The argument is that being a member of the Euro means countries need to follow fiscal responsibility otherwise they will be a divergence in bond yields putting stress on the Euro economy.

It is argued governments have political pressure to borrow more, so rules help to keep borrowing under prudent limits.

The problem is that under certain circumstances it may be better for countries to borrow more than 3% of GDP.

In a recession, automatic fiscal stabilisers mean taxes fall and benefits rise. This helps to cushion the impact of a recession by increasing government borrowing

However, for some countries a recession may mean breaking the fiscal rules, therefore to stick to the growth and stability pact may require higher taxes and lower spending. This will reduce consumer spending and economic activity making the recession worse.

This is what governments in UK and US did in 1931 in response to the great depression. It meant that the depression just got deeper and worse.

It is not surprising many countries have ignored the rules and borrowed more.

This does not mean that fiscal responsibility is not a good thing. Governments should seek to maintain fiscal responsibility and reduce budget deficits - especially during boom years. However, in a recession, the last thing you want is to be burdened with rules forcing you to increase taxes and deflate the economy.

In the UK's case if we had been constrained by fiscal and stability rules we would have seen an increase in VAT rather than cut in VAT. This would have led to big fall in economic activity.

Consider the case of Spanish Economy

  • They are entering into a recession.
  • The housing boom has turned to a painful bust.
  • Unemployment already at an EU high of 15% is rising again.
  • Construction sector has been hard hit by the credit crisis and the fall in house prices

It is little comfort that Spain's banks avoided the worst excesses of subprime lending fiasco. Compared to Britain and American banks, Spanish banks have been a model of common sense. Yet, they still find themselves facing a recession with few policy options available.
  • Monetary Policy - Interest rates are set by the ECB for the whole eurozone area. Cuts depend on inflation prospects in Germany as much as recession on the periphery of the Eurozone.
  • Growth and stability pact states member countries can borrow a maximum of 3% of GDP. This means that in theory, Spain will have to respond to recession by fiscal tightening - increasing taxes and cutting spending - something which will make the recession worse. This is why many call it the growth and stupidity pact.
  • Devaluation. No scope for devaluation to improve current account deficit or improve competitiveness.


Lawrence Low said...

Hi, kinda confusing. Perhaps you can check on this link.

Public debt = national debt?

And ya, would like to clarify if the maximum amount borrowed within the EU pact is 3% of GDP, but then the UK's is now 47% of GDP that high?

Thanks so much

Tejvan Pettinger said...

In the US, the National debt is said to be the gross debt = public sector debt + funds held by the government (e.g. social security funds)

In the UK, the ONS equate government debt to public sector debt. They do not seem to publish two sets of data like in the US

The 3% rule is related to annual government borrowing. (PSNCR)

The 47% is the total cumulative debt.