Something Worries Me About Peter Bofinger

Really I realise I have been remiss in another important sense. I have long assumed that in fact the decision to reduce deficits was taken due to the coming fiscal pressure from ageing. This certainly was the background to the discussion. However now I look at the details of the SPG this area is not mentioned (as far as I can see) and the other – the free rider and associated – is the principal consideration.

So those who criticize the bureaucratic and infexible nature of the ECB are in the right to this extent. Of course the underlying demographics *should* be part of the pact, but that is another story.

I find myself in a tricky situation, since I am deeply sceptical that the euro can work, and now after the French vote even more so, but since it has been set in motion, the best thing is obviously to try and make it work (even while doubting). So I am thinking about all this. Obviously I should try and write a longer post making this clearer.

The SGP was adopted at the Amsterdam Council 1997. A history of the implementation of the pact, and a summary of the debate over the new pact can be found here. The Stability and Growth Pact was designed as a framework to prevent inflationary processes at the national level. For this purpose it obliges national governments to follow the simple rule of a balanced budget or a slight surplus.

Now if we go back to the origins of the pact, to the communication of the European Commission on 3 September 2004, you will find the following:

“As regards the debt criterion, the revised Stability and Growth Pact could clarify the basis for assessing the “satisfactory pace” of debt reduction provided for in Article 104(2)(b) of the Treaty. In defining this “satisfactory pace”, account should be taken of the need to bring debt levels back down to prudent levels before demographic ageing has an impact on economic and social developments in Member States. Member States’ initial debt levels and their potential growth levels should also be considered. Annual assessments could be made relative to this reference pace of reduction, taking into account country-specific growth conditions.”

Now curiously I have found nothing in Bofingers argument which seems even to vaguely recognise this background.

A good starting point for this topic would be the conference “Economic and Budgetary Implications of Global Ageing held by the Commission in March 2003.

The European Council in Stockholm of March 2001
agreed that ?the Council should regularly review the
long-term sustainability of public finances, including the
expected strains caused by the demographic changes
ahead. This should be done both under the guidelines
(BEPGs) and in the context of the stability and
convergence programmes.?

This document on the history of EU thinking on ageing and sustainability is incredible.

Bofinger (2004) suggests 3 general areas where fiscal policy rules may be useful.

“First, there is no guarantee that the independent actions of 12 national governments lead to an aggregate policy stance that is adequate to the overall macroeconomic situation in the euro area. Above all, smaller countries might be tempted to avoid their contribution to a necessary macroeconomic stabilisation. This externality could prevent an adequate fiscal policy response of the euro area in the case of demand shocks.”

“Second, overly expansionary national fiscal policies could lead to inflationary pressure in parts of the euro area. In contrast to a nation state with an autonomous national central bank, the ECB is not able to retaliate such an individual policy directly, especially if it is caused by a relatively small country.”

“Third, under the umbrella of a single currency, an individual country could pursue an unsustainable fiscal policy since there is no longer the threat of a depreciation of its currency. In addition the sanction exerted by financial markets could be too weak or it could come too late since market participants might expect a ?bail-out? by other EMU members or by the ECB.”

If the SGP is regarded as a framework that contributes to price stability, it suffers from the weak link between government deficits and inflation. This is due to the fact that a negative budgetary position can be caused by excessive government spending but also by a dismal growth performance. For the aim of price stability it makes no sense to sanction countries with weak growth and inflation rates below the ECB?s target.

However, by using a flawed rule the risk of biases becomes very high.

The Stability and Growth Pact is a child of German ?Angst?. It was proposed in 1995 by the former German Minster of Finance Theo Waigel as a Stability Pact in order to dampen the widespread fears in the German public that the Euro would become a less stable currency than the D-Mark. In the political debate the Pact was modified verbally into a Stability and Growth Pact. Thus, the Resolution of the European Council on the Stability and Growth Pact, which was decided at the Amsterdam European Council on 16 and 17 June 1997, states:

?The European Council underlines the importance of safeguarding sound government
finances as a means to strengthening the conditions for price stability and for strong
sustainable growth conducive to employment creation. It is also necessary to ensure
that national budgetary policies support stability oriented monetary policies.?

Thus, the architects of the SGP pretended that both aims, price stability and growth, could be achieved by a simple rule for fiscal policy that is applicable in all member countries:

Today, the economic challenges have changed. The fear of inflation and a weak euro is no longer on the agenda. Instead many member countries suffer from weak growth and increasing unemployment.

Actually there is one particularly revealing quote from Bofinger himself:

Although EMU member countries differ, e.g.

* in GDP per capita from 12,500 Euro in Portugal to 50,100 Euro in Luxembourg,
* in their debt levels positions from 5.7 % of GDP in Luxembourg to 106.7 % in Italy, and
* in unemployment from 2.8 % in the Netherlands to 11.4 % in Spain,

the SGP presumes ?one fits all?.

In fact this argument applies to monetary policy in the euro area as a whole, not simply to the SGP.

Another interesting quote:

“The attractiveness of monetary targeting was due to the fact that it seemed to rely on a solid theoretical foundation: the quantity theory of money, which provided the growth rate of the money, stock M3 as cue for this heuristic. Unfortunately, most economists and politicians did not realise that this theory is useful only in the context of high inflation but very misleading in an environment with moderate increases of the price level where M3 is mainly used as a store of value.”

“The German fears, which led to the creation of the SGP, were based on the experience of the 1970s and 1980s when some countries, notably Italy, with high deficits and a high debt level experienced double-digit inflation rates. However, already in the 1990s it should have been obvious that the link between public debt or deficits and inflation is very weak, at least in OECD countries with relatively moderate inflation rates.”

“Above all, there is no theoretical framework with which would provide concrete values for a sustainable debt to GDP ratio. Without such a benchmark it is also not possible to derive a concrete value for the deficit to GDP ratio, which determines the path of the debt to GDP ratio over time. The Maastricht Treaty solved this problem in a pragmatic way by defining the average debt to GDP level of the year 1990 as benchmark. It derived the 3 % threshold under the assumption that deficits of that size would keep a 60 % debt ratio constant as long as nominal GDP grows 5 % per annum.”

“The much stricter balanced-budget rule of the SGP is more difficult to justify. In fact, the designers of the pact never tried to provide such a theoretical explanation. The only rationale of this heuristic is a reduction of the ratio of public debt to GDP over time. With a 5 % growth rate of nominal GDP a debt level of 60 % to GDP is reduced to 15 % in 30 years and to 9 % in 40 years. However, this raises again the unresolved question of an optimum ratio of public debt to GDP. Given an increasing demand for safe investments to build up capital-funded pension schemes it is questionable whether such low debt to GDP ratios constitute an optimum solution for the euro area countries.”

“In sum, there is no doubt that the SGP lacks a sound theoretical framework. Its implicit target of a permanent reduction of the debt to GDP ratio has not even been discussed in the academic or the political arena.”

EU parliament paper:

“Thus, in retrospect the main macroeconomic players in the euro area have adopted a much less active role than in the United States. Together with the depreciation of the dollar this insufficient macroeconomic stabilisation can be regarded as the main reason for the underperformance of the euro area in the last few years.”


Pro cyclical and disinflationary stances: we lack yardsticks.

“Moreover, Member States used the windfall from the drop in the
interest burden to raise spending rather than to accelerate debt reduction, thereby worsening the sustainability of debt.”

“Continuous compliance with the medium-term objectives as suggested by the
Commission would lead explicit debt to converge over time to a level of about 40% of
GDP (and lower for countries with high growth rates). This approach is however
based on the strong assumption that all policy measures are taken in order to ensure that the objective is respected over time. As such it presupposes that structural
reforms and/or budgetary measures are taken to fully tackle all risks to sustainability
stemming for example from increasing pension or health expenditures related to
ageing. Should that not be the case, then increasing difficulties would be faced by
governments in respecting the medium-term objectives, unless more ambitious
budgetary positions are already taken now, and debt levels are brought down more
rapidly.13 Countries have therefore the choice, within the limits set by such objectives,
as to which strategy they want to pursue in order to remain sustainable and deal with
long-term developments: realise the necessary reforms, implement more restrictive
budgetary policies over the next decade, or choose a combination of the two.
An open issue is whether (and to what extent) the medium-term budgetary objectives
should explicitly take into long-term sustainability (implicit liabilities).14

See for instance Regling (2002) for the strategy suggested by the Commission to address the
challenges of ageing populations: ?(?) (to address the important economic, social and budgetary
challenges posed by the ageing populations), the Commission recommends that member states
pursue a comprehensive strategy, including reform of pension and health care systems, in order
to place them on a sound financial footing, and efforts to increase employment. Such measures
would also contribute to the necessary safeguarding of sustainable public finances. As a result of
population aging, the risk cannot be ruled out that large budgetary imbalances – in breach of the
requirements of the Stability and Growth Pact – may emerge in the future in several countries. In
this context, delays in budgetary consolidation could have long-term consequences as there is
only a limited window of opportunity to prepare before the impact of demographic changes
begins to be felt.?

Regling K.P. (2002) ?Europe is Doing Well, but Needs Further Reforms?, in Special
Report: Managing Europe’s New Money, European Affairs, Spring 2002 Volume 3
– Number 2.