BRUSSELS – The European Union is a voluntary quasi-federation of sovereign and democratic states in which elections matter and each country seeks to determine its own destiny, regardless of the wishes of its partners. But it should now be apparent to everyone that the eurozone was designed with a very different institutional arrangement in mind. Indeed, that design gap has turned out to be a major source of the monetary union’s current crisis.
Last October, Greece’s then-prime minister, George Papandreou, proposed a popular referendum on the second rescue package that had just been agreed at the EU’s summit in Brussels. He was quickly told off by German Chancellor Angela Merkel and former French President Nicolas Sarkozy, and Greeks never voted on it.
But, less than a year later, the referendum is de facto taking place anyway. In a union of democracies, it is impossible to force sovereign countries to adhere to rules if their citizens do not accept them anymore.
This has profound implications: all of those grandiose plans to create a political union to support the euro with a common fiscal policy cannot work as long as EU member countries remain both democratic and sovereign. Governments may sign treaties and make solemn commitments to subordinate their fiscal policy to EU rules (or to be more precise, to the wishes of Germany and the European Central Bank). But, in the end, the “people” remain the real sovereign, and they can choose to ignore their governments’ promises and reject any adjustment program from “Brussels.”
In contrast to the United States, the EU cannot send its marshals to enforce its pacts or collect debt. Any country can leave the EU, and thus the eurozone, when the perceived burden of its obligations becomes too onerous. Until now, it had been assumed that the cost of exit would be so high that it would never be considered. That is no longer true, at least for Greece.
But, more broadly, EU commitments have now become relative, which implies that jointly guaranteed Eurobonds cannot be the silver bullet that some hope. As long as member states remain fully sovereign, no one can fully reassure investors that in the event of a eurozone breakup, some states will not simply refuse to pay, or at least refuse to pay for the others. It is not surprising that bonds issued by the European Financial Stability Facility (the eurozone’s rescue fund) are trading at a substantial premium over German debt.
All variants of Eurobonds come with supposedly strong conditionality. Countries that want to use them must follow strict fiscal rules. But who guarantees that these rules will actually be followed? François Hollande’s victory over Sarkozy in France’s presidential election shows that an apparent consensus on the need for austerity can crumble quickly. What recourse do creditor countries have if the debtor countries become the majority and decide to increase spending?
The recently agreed measures to strengthen economic-policy coordination in the eurozone (the so-called “six pack”) imply in principle that the European Commission should be the arbiter in such matters, and that its adjustment programs can formally be overturned only by a two-thirds majority of the member states. But it is unlikely that the Commission will ever be able to impose its view on a large country.
Spain’s experience is instructive in this respect. After the recent elections there, Prime Minister Mariano Rajoy’s new government announced that it did not feel bound by the adjustment program agreed to by the previous administration. Rajoy was roundly rebuked for the form of his announcement, but its substance was proven right: Spain’s adjustment program is now being made more lenient.
The reality is that the larger member states are more equal than the others. Of course, this is not fair, but the EU’s inability to impose its view on democratic countries might actually sometimes be for the best, given that even the Commission is fallible.
The broader message from the Greek and French elections is that the attempt to impose a benevolent creditors’ dictatorship is now being met by a debtors’ revolt. Financial markets have reacted as strongly as they have because investors recognize that the “sovereign” in sovereign debt is an electorate that can simply decide not to pay.
This is already the case in Greece, but the fate of the euro will be decided in the larger, systemically important countries like Italy and Spain. Only determined action by their governments, supported by their citizens, will show that they merit unreserved support from the rest of the eurozone. At this point, nothing less can save the common currency.
Daniel Gros is Director of the Center for European Policy Studies.
Copyright: Project Syndicate, 2012.
Austerity and Debt Realism
By Kenneth Rogoff
CAMBRIDGE – Many, if not all, of the world’s most pressing macroeconomic problems relate to the massive overhang of all forms of debt. In Europe, a toxic combination of public, bank, and external debt in the periphery threatens to unhinge the eurozone. Across the Atlantic, a standoff between the Democrats, the Tea Party, and old-school Republicans has produced extraordinary uncertainty about how the United States will close its 8%-of-GDP government deficit over the long term. Japan, meanwhile is running a 10%-of-GDP budget deficit, even as growing cohorts of new retirees turn from buying Japanese bonds to selling them.
Aside from wringing their hands, what should governments be doing? One extreme is the simplistic Keynesian remedy that assumes that government deficits don’t matter when the economy is in deep recession; indeed, the bigger the better. At the opposite extreme are the debt-ceiling absolutists who want governments to start balancing their budgets tomorrow (if not yesterday). Both are dangerously facile.
The debt-ceiling absolutists grossly underestimate the massive adjustment costs of a self-imposed “sudden stop” in debt finance. Such costs are precisely why impecunious countries such as Greece face massive social and economic displacement when financial markets lose confidence and capital flows suddenly dry up.
Of course, there is an appealing logic to saying that governments should have to balance their budgets just like the rest of us; unfortunately, it is not so simple. Governments typically have myriad ongoing expenditure commitments related to basic services such as national defense, infrastructure projects, education, and health care, not to mention to retirees. No government can just walk away from these responsibilities overnight.
When US President Ronald Reagan took office on January 20, 1981, he retroactively rescinded all civil-service job offers extended by the government during the two and a half months between his election and the inauguration. The signal that he intended to slow down government spending was a powerful one, but the immediate effect on the budget was negligible. Of course, a government can also close a budget gap by raising taxes, but any sudden shift can significantly magnify the distortions that taxes cause.
If the debt-ceiling absolutists are naïve, so, too, are simplistic Keynesians. They see lingering post-financial-crisis unemployment as a compelling justification for much more aggressive fiscal expansion, even in countries already running massive deficits, such as the US and the United Kingdom. People who disagree with them are said to favor “austerity” at a time when hyper-low interest rates mean that governments can borrow for almost nothing.
But who is being naïve? It is quite right to argue that governments should aim only to balance their budgets over the business cycle, running surpluses during booms and deficits when economic activity is weak. But it is wrong to think that massive accumulation of debt is a free lunch.
In a series of academic papers with Carmen Reinhart – including, most recently, joint work with Vincent Reinhart (“Debt Overhangs: Past and Present”) – we find that very high debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more. The cumulative costs can be stunning. The average high-debt episodes since 1800 last 23 years and are associated with a growth rate more than one percentage point below the rate typical for periods of lower debt levels. That is, after a quarter-century of high debt, income can be 25% lower than it would have been at normal growth rates.
Of course, there is two-way feedback between debt and growth, but normal recessions last only a year and cannot explain a two-decade period of malaise. The drag on growth is more likely to come from the eventual need for the government to raise taxes, as well as from lower investment spending. So, yes, government spending provides a short-term boost, but there is a trade-off with long-run secular decline.
It is sobering to note that almost half of high-debt episodes since 1800 are associated with low or normal real (inflation-adjusted) interest rates. Japan’s slow growth and low interest rates over the past two decades are emblematic. Moreover, carrying a huge debt burden runs the risk that global interest rates will rise in the future, even absent a Greek-style meltdown. This is particularly the case today, when, after sustained massive “quantitative easing” by major central banks, many governments have exceptionally short maturity structures for their debt. Thus, they run the risk that a spike in interest rates would feed back relatively quickly into higher borrowing costs.
With many of today’s advanced economies near or approaching the 90%-of-GDP level that loosely marks high-debt periods, expanding today’s already large deficits is a risky proposition, not the cost-free strategy that simplistic Keynesians advocate. I will focus in the coming months on the related problems of high private debt and external debts, and I will also return to the theme of why this is a time when elevated inflation is not so naïve. Above all, voters and politicians must beware of seductively simple approaches to today’s debt problems.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.
Copyright: Project Syndicate, 2012.