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If the European financial, economic, and budget crises of the last two years have proven anything, it is that the famous Stability and Growth Pact (SGP) established in 1997 turned out to be nearly useless as an instrument of discipline. This week the European Union’s finance minister, basically agreed to keep it that way.
Meeting this week in Brussels, the ministers decided to maintain the SGP as an essentially "political instrument," subject to at least two votes by euro area governments before any sanctions can be imposed on fiscally sinful members. Thus any sanctions under the SGP are not even close to "quasi-automatic." It is a safe bet that they will never be imposed on any large member of the eurozone. The mutual nonaggression pact among large countries that prevailed in 2003–04, when France and Germany gutted the original SGP, will prevail also in the future.
In typical European decision-making fashion, the details allow everyone to claim victory. Hence, it remains the case—as the European Commission proposed earlier—that countries can be fined, based upon a proposal from the European Commission unless a qualified majority of member states veto this decision, up to 0.2 percent of GDP. Accordingly, the "quasi-automaticity" can be claimed—as the German finance ministry has done—to remain in place.
So far, so good. However, there’s now a little addition in front of the "quasi-automatic" part to the process leading to sanctions. Currently the EU Council must first vote on whether a member is in "excessive deficit," which happens routinely and only Luxembourg is currently not in that condition.
Under the new system, once such a vote is taken, the fiscal wayward member has six months to show sufficient progress toward rectifying the situation to the EU Council and the European Commission. The EU Council must then establish whether or not the member state has in fact done so. Only if the Council decides "no" can sanctions be applied. And this decision still requires a regular majority.
In other words, whether the "quasi-automatic" aspects of the SGP are implemented remains political. And that is just another way of saying that it won’t ever be! The "preventive framework" of fiscal surveillance in Europe has been given more bite, but the "corrective measures" remain toothless.1 This has several implications.
This decision amounts to a massive failure for the European Commission—it will not have unchecked power to suggest penalties on member states. A potentially enormous power grab by Brussels has been averted by a majority of member states. Elected national politicians have resisted enhanced powers for unelected eurocrats.
It also means that enforcement of fiscal discipline via the SGP and the other political institutions of EU budget surveillance will never materialize. The SGP will be able to name and shame, but without real effect on (large) countries’ behavior. Institutionalization and rules-based governance—the European Union’s traditional preferred methods of operation—have correspondingly failed in this case.
None of this means, however, that fiscal sustainability cannot or will not be enforced in the European Union/eurozone, or that there isn’t a lot that EU policymakers can do to ensure that moral hazard is kept in check. There are other ways to achieve this objective than through the SGP.
At least two policy options other than an enhanced SGP emerged from the recent meeting of President Nicolas Sarkozy of France and Chancellor Angela Merkel in Deauville on October 18.
First is the Franco-German proposal to change the EU Treaty by 2013 to potentially strip member states that run excessive deficits of their votes in the EU Council. This proposal—which would require a politically prohibitive change in the EU Treaty and probably referenda among many member states—is like a "nuclear option" in the EU decision-making process. If adopted, it would potentially be a great deterrent, but you’d hate to have to use it.
Given the way the European legislative process works,2 it is not credible to suggest that any member state—and certainly not a large one—could be stripped of its voice in the EU Council. Such a move would only produce rampant anti-EU sentiment in any state that is punished, undermining political support for the European Union among the political elites. The proposal is simply be too undemocratic to be feasible.
The interesting Franco-German proposal is the second one, however. It states that EU Treaties could be changed to allow for:
The establishment of a permanent and robust framework to ensure orderly crisis management in the future, providing the necessary arrangements for an adequate participation of private creditors and allowing member states to take appropriate coordinated measures to safeguard financial stability of the euro area as a whole.
This suggests that France, in return for German acceptance of a permanent European Financial Stability Facility3 (EFSF), has accepted the German demand for haircuts for private creditors in any future European bailouts.
This is critical for several reasons.
First, this follows the thinking behind the introduction by the European Central Bank (ECB) of haircuts for its collateral for eurosystem market operations, scheduled to begin Jan 1, 2011. This action sets a precedent for haircuts on private creditors’ holding of eurozone sovereign debt. (Depending on rating, coupon, and maturity, the new ECB haircuts on sovereign debt collateral can reach 13.5 percent.)
Second, haircuts for private creditors in future bailouts will be extremely politically popular among taxpayers—a requirement if more public money for bailouts must be spent. This is particularly so, now that the risks of haircuts causing a systemic European banking crisis arising has subsided since May.
Moreover, while it looks on the surface like Angela Merkel simply caved in to French demands on the SGP, the reality is more likely that she simply shifted the emphasis in the German demands away from a tougher SGP (and EU institutions) and toward forcing private creditors to participate in any future EU bailouts.
Germany’s performance leading up to the May 2010 approval of the Greek bailout supports such an interpretation. Recall how the opposition Social Democrats abstained from supporting the Greek program over its dissatisfaction with the lack of "private participation" in the Greek program. Similar vocal voices for private sector participation—i.e., "haircuts"— have since been heard among other governing parties. In Germany at least, it looks clear that no more taxpayers’ money will go to bailouts without private sector participation.4
Third, it is not clear that this proposal requires a change in the EU Treaty. Member states could agree to appropriate covenants on their sovereign debt—for instance in return for German acceptance of a permanent EFSF—without such a change. As discussed in von Hagen (2010), such voluntary bond covenants would create a two-tier sovereign bond market for a period, but otherwise pose relatively few practical obstacles.
It would be preferable to enshrine a European sovereign debt restructuring mechanism (an E-SDRM closely aligned with a 2002 proposal by the International Monetary Fund5) in the EU Treaty. But given the political constraints on changing the EU Treaty, it is important to remember that such a treaty change may not be required.
Fourth, an E-SDRM would—irrespective of what a future accord on risk-weighting of sovereign debt—shatter the notion that peripheral sovereign debt in Europe is "risk free." In a monetary union where bailouts are the norm, this mechanism will help contain moral hazard.
An E-SDRM with automatic haircuts for private creditors would also ensure that financial markets pay attention to longer-term sustainability of economic and fiscal policies in the eurozone. It would further banish the risk that "fickle financial markets" could return to their old status of going AWOL, as they did when ignoring the risk differentials in eurozone sovereign debt before the Greek collapse.
Finally, an E-SDRM could render the SGP irrelevant, ensuring that financial markets impose fiscal sustainability on countries in real time and punish laggards with potentially large sovereign default premia on their bonds.
The financial costs to countries of losing AAA ratings or generally being perceived by financial markets as on an unsustainable path could be very large in terms in yield increases. Another way to put this is that the German financial advantage in cost of capital inside the eurozone with an E-SDRM would be permanent. A company in Germany would always have access to cheaper capital than a similar company in Greece because of the sovereign risk differentials.
It is therefore not a coincidence that President Sarkozy agreed to German demands for an E-SDRM in the same week that he pushed a crucial increase in the retirement age. A France with its future fiscal house in order and a solid AAA rating would not suffer harm from an E-SDRM in terms of its bond yields. Only the weaker peripherals would suffer from higher yields. French bonds would thus track Germany closely under the new accord. Provided, of course, that Sarkozy succeeds in his austerity measures, an E-SDRM is "free" for France and certainly less politically costly than the prospects of "automatic SGP sanctions." Thus it is perhaps not surprising that the two core EU countries can agree on these fundamentals.
Fifth, if the EFSF expires as planned in 2013, financial markets will likely question the EU political resolve and capacity for more bailouts. The predictable result will be wider sovereign bond spreads for peripheral eurozone member states. It is not clear whether these peripheral countries would suffer higher yields more from a eurozone with an E-SDRM than from a eurozone without one. Hence, opposition to the E-SDRM may be muted, and Germany has a strong hand.
In sum, France and Germany have obliterated the credibility of the SGP while outsourcing enforcement of fiscal sustainability to an E-SDRM and thus de facto to financial markets. The result is likely to limit moral hazard in Europe and promote long-term fiscal sustainability, at the expense of institutions in Brussels.
Notes
1. "Preventive measures" of fiscal surveillance include things like early warning systems, the "European Semester," and generally enhanced economic coordination. "Corrective measures" are the potential financial sanctions imposed on members in excessive deficit, as well as potential losses of EU funds or voting rights or any other coercive measures.
2. The precise scope of EU legislation in Europe is a highly contested issue.
3. The EFSF is currently valid for three years and set to expire in May 2013, a few months before the next German national election.
4. The fact that the German private financial sector in May 2010 volunteered to "hold on to their Greek exposure" moreover illustrates that they were well aware of the political strength of demands for "private sector" participation. Such demands will be far more powerful in the future.
5. See Krueger (2002) A New Approach to Sovereign Debt Restructuring .
