Monolithic fiscal discipline is not a solution but a problem

2012-02-06

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The greatest fallacy of our times is the belief that the crisis is caused by the lack of fiscal discipline.

The fiscal compact, the new international treaty that will impose stricter budget rules on its signatory states, is considered by many as the only realistic solution to the ongoing crisis. The political forces pushing for the ratification of this treaty have identified the causes of the crisis in the excessive fiscal finances of some states. They advocate that the debts/deficits of Greece, Ireland, Portugal, Italy and Spain are what create uncertainty about the integrity or even the viability of the eurozone. Though it is an undisputable fact that certain fiscal finances were/are not in good shape and could indeed be the weak spot of the euro edifice, the assertion that these alone have brought us to this point is misleading as it omits several parameters of the actual crisis, while it completely neglects the dynamics in the real economy and the financial sector, clinging only to a few fiscal indices – which by the way show little and mislead a lot as they are imperfect macroeconomic aggregates.

Had the discussion been about the role of the state in the economy, or the ideal degree of government spending, it would indeed make sense to speak of fiscal discipline. Yet the eurozone is much more than a laboratory “optimal currency area”, whereby academics can apply their theories under ceteris paribus conditions. The eurozone is a very complex and dynamic system as:

1. It is a currency union without a fiscal union backing it – this is unique in capitalist history.
2. It encompasses 17 nation-states with diverse economic models, public administrations, cultures and political systems. Thus it is not a unified entity by any measure, economic, legal, social or political.
3. It is influenced by the broader EU architecture, which is in itself a sui generis entity; while it is also connected to the world economy and the dynamics of international trade.

The above would have been enough to suggest that no easy answers exist along these lines. Hence no one-sided proposal, such as the monolithic fiscal compact, could possibly be an effective remedy. Yet there is much more to the argument than abstract observations of the essence and form of the eurozone, since real world facts also are against the arguments of the narrow-sighted acolytes of fiscal discipline.

In particular, the current crisis, started as a financial crisis in Wall Street which spread to the European financial system. The super-speculators of Wall Street proved to be much less greedy than their European counterparts, since at the time the leverage ratios across the eurozone where significantly higher than those across the Atlantic. When the average leverage ratio (debt to equity) in Wall Street was approximately 30/1, in Europe it was around 50/1. Had European banks been austere and conservative, they would have never fallen into such a crisis, which brought the need for massive bank bailouts that have been taking place ever since 2008 either directly or indirectly (and of course when a state finances its banks on a massive scale, it can fall on a debt crisis itself – a vicious cycle).

Moreover countries like Ireland or Spain who have been seen as members of the “PIIGS”, had impressive fiscal finances prior to the collapse of Wall Street, yet these failed to protect them from the negative dynamics of the crisis. For instance the public debt of Ireland was a mere 24.9% to GDP in 2007 and 41.8% in 2008 when the crisis came in. Also its government budget was either on surplus or on ancillary deficit prior to 2008. Similar story for Spain, which had better fiscal finances than Germany before the crisis. These two countries are enough to suggest that fiscal finances alone, do not mean much, when a crisis of such proportions hits us. So why did these two countries fall into trouble since their finances were in good shape? Ireland had to bail out its private banks, who were seriously hit by the financial crisis, while Spain suffered from the collapse of the housing bubble and from rigidities in its labor market. In short the financial and real economies of these two countries were the source of trouble, not the state’s finances.

The logical conclusion here is that if a fiscal compact with automatic sanctions – that is with extra costs on states in recession – existed prior to 2008 it would have failed to control the situation, while it could easily make things worse. The gist is that the economy is a complex system and the eurozone an even more complex entity. To find solutions one needs to take into account all parameters. Failing to do so, implies an inability to see the whole picture, or a dogmatism that verges on being dangerous for the common good of the Eurozone.

With these and many other secondary issues in mind, I maintain the view that the monolithic fiscal discipline that is being propagated as a solution to the crisis, will fall short of its expectations. Only when European leaders start thinking outside the box will they find a viable solution for the benefit of all Europeans – and indeed the whole world.