Carlo Clericetti – The wrong rules of a vanished world

The European rules are suspended, but the hypotheses for change do not bode well.

Carlo Clericetti is an Italian journalist. In the past he has directed “Affari & Finanza”, a weekly supplement published by “La Repubblica”, and web portals. Currently he  blogs for “La Repubblica”, for his personal website “Blogging in the wind”, and writes for other websites on economy and politics.

Cross-posted from la Repubblica

Translated and edited by BRAVE NEW EUROPE

An important factor for the future of Europe is that of European rules, which have been suspended because of the pandemic, but will sooner or later come back into force. These rules have strongly conditioned economic policies, both at the level of the Union and at that of individual countries, and an a posteriori judgement on the effects they have had cannot leave any doubts: they are largely wrong rules, in some cases blatantly wrong. We have been coming to this conclusion for many years now: mind you, not for many months, but for many years. And yet they continue to be applied, albeit with a few mitigating factors – the famous ‘flexibility’ – but these are by no means sufficient to correct what are genuine errors of approach.

Even before the Covid crisis, there was talk of reform, and various proposals were drawn up. This interruption should serve to reach an agreement, so that when the suspension is declared to be over, a renewed ‘package’ comes into force. According to the most recent statements, the suspension will continue throughout 2022 and will end – according to a statement by Commission Vice-President Valdis Dombrovskis – in 2023. The precise date remains undetermined (it would obviously be different if the decision was taken in January or December of that year) and will probably depend on when agreement is reached on the changes.

But before looking at what proposals we are talking about, it is worth recalling the logic behind the current rules. They are the transposition of a series of principles derived from economic theories commonly referred to as ‘neo-liberalism’, in this case according to ‘ordoliberalism’, the German version. According to these theories, the market naturally tends towards equilibrium and the task of institutions is to ensure that market forces can be exercised in the best possible way. The rules therefore provide for the protection of competition, a ban on state aid, an independent central bank whose primary task is to control inflation and which cannot finance states directly, public budgets that tend to be balanced including investment expenditure. In short, the construction of a “cage” that eliminates as far as possible the discretionary choices of economic policy.

Of course, the Treaty also provides for “full and good employment”. But beware, when we talk about “full employment” in this context there is a catch. Because full employment is considered as such when it coincides with the Nairu (Non-Accelerating Inflation Rate of Unemployment). The notion would be that if employment were indeed ‘full’ this would cause wage pressures, which would not only increase inflation, but also cause it to rise continuously (‘accelerate’) and get out of control. There is a “memory” here of the high inflation of the 1970s, which were also years of wage claims in many countries. That inflation was driven mainly by the oil crises, which tripled the price of crude oil in a decade, and by the financing of the war in Vietnam, which obviously matters less.

Nairu is a very important factor in the calculation of potential GDP, which is the growth rate that can be achieved with the optimal use of production factors. The difference between potential and actual GDP constitutes the output gap, on the basis of which the technical bodies of the Commission determine how much one can deviate from the rules in order to take the economy into account. This all sounds very rational. The problem is that the test of reality has shown a resounding failure of these calculations. The Nairu, in essence, is a sort of moving average of past years: thus, the deeper the crisis, the higher the ‘structural unemployment’ (i.e. the Nairu) and the smaller the output gap. As a consequence, the budget space that is granted in an anti-cyclical function is too little. Also because potential GDP is a quantity that can only be estimated, and the estimates of the last decade have ALWAYS been wrong: partly because of an excess of optimism about the effectiveness of the prescribed policies, partly because the econometric models in use had been rendered unsuitable by the dimension of the 2008-9 crisis. We have thus witnessed forecasts that would have been comical if their effect had not been dramatic, such as the one according to which Italy’s potential GDP in 2019 would be lower than its actual one, a sign of an overheated economy: as we will recall, the change in the year was eventually 0.3%. More than overheated, a frozen growth.

On the basis of those accounts, however, the Commission required us to reduce the public deficit, which the programmatic budget had set at 2.4%, thus below the 3% of the Maastricht Treaty, but not in line with the progressive reduction of the debt established by the Fiscal Compact. Moreover, the deficit was only due to debt servicing, because the primary balance (revenue minus expenditure net of interest) would have been positive at 1.6% of GDP, as has been the case – with the exception of just two years – since 1992. A policy of rigour that no other European country could have boasted of, which we paid for with stunted growth that was lower than our European partners.

This example should have made it clear that European rules – especially those contained in the Fiscal Compact, which define the parameters for evaluating debt reduction – are wrong and, what is worse, harmful, because they force the implementation of pro-cyclical policies. Given the economic situation, the deficit of 2.4% – with a positive primary balance – should have been increased, not reduced. Italy had posed the problem of the methodology as early as 2014, but only minor adjustments were made that did not change the substance at all.

It took the start of an international campaign by economists who are certainly not heterodox to finally begin to stir things up. Robin Brooks, chief economist of the IIF (Institute of International Finance, a global association of financial institutions) launched the hashtag #CANOO (campaign against nonsense of outputgaps) on Twitter, showing the absurdity of the results of that method with graphs, and he was joined by other authoritative economists such as Adam Posen, president of the Peterson Institute, and the historian Adam Tooze.

The fact that an unreliable and brainless methodology is being abandoned is certainly good news, but it is by no means certain that the one that will replace it will bring will be any better. The prevailing policy in Europe is still the one that the Nordic countries, especially Germany and the Netherlands, have imposed since Maastricht and subsequently made even more stringent: consolidation of public finances first and foremost, with its corollaries of deficit limits and debt reduction. If the objectives do not change, the new methodology will also be chosen in such a way as to be functional to their interests.

In fact, the reform proposal prepared by the European Fiscal Board (or European Advisory Committee on Public Finances, CCEFP) introduces some apparent improvements, but is under the banner of absolute continuity. In fact, Valdis Dombrovskis, the vice-president of the Commission who has never missed an opportunity to call for respect for the rules (yes, those absurd rules) and for “rigour”, has declared: “We are working on the revision of the regulations and directives of the ‘six-pack’ and the ‘two-pack’: in practice we are taking stock of the current situation and assessing how the budgetary rules have worked in recent years, and how to simplify them. In September (2019; but because of the pandemic it did not go ahead) the finance ministers already discussed the possible solution on the basis of a proposal of the European Fiscal Board, which I think is a good basis in terms of simplification.The proposal is to abandon unobservable indicators such as the structural budget balance or the output gap”.

Perhaps Dombrovskis did not read the proposal well, because potential GDP does not actually disappear, but is calculated over ten years (the previous five and the following five) so as to be more stable: but this does not make it free of defects. But that is not the only problem. The new main parameter is supposed to be the growth rate of nominal public expenditure, calculated without taking into account non-permanent revenues or cyclical expenditure, such as unemployment benefits that increase in recessions. A derogation clause is also envisaged, for special events and to be granted on the basis of the judgement of an independent body. The target for expenditure is set for the end of the following three-year period, leaving governments the choice of spending more in one year while saving more in the next. The introduction of a “limited” golden rule is also proposed: investment expenditure on projects identified in the EU budget would be excluded from the calculation of expenditure growth, including expenditure in excess of co-financing commitments. The independent bodies of each state (in Italy, the Parliamentary Budget Office) would also be responsible for monitoring this expenditure, to prevent governments from being clever by counting other expenditure under these headings.

There are also other suggestions, such as the abolition of qualified majority voting in the Commission, a stable president for the Eurogroup chosen from outside it, and a change in the system of sanctions: instead of sanctions, the fiscal capacity of the Union would be strengthened (another way of proposing Eurobonds), but those who do not comply would be excluded from the funds. The debt reduction target would be set country by country, not with a one-size-fits-all rule as at present, with those with high debts committing to reduce them and those with low debts having to increase public investment spending, especially those with a surplus in their foreign accounts: this is the invitation that has been made so many times, particularly to Germany and the Netherlands, which have always quietly ignored it. We do not propose to comment on all these points here, which would take a long time. Let us limit ourselves to examining what would change with regard to debt reduction, which remains the fundamental objective.

Massimo D’Antoni and Gianluigi Nocella have carried out a study on this subject for the Mulino annual report “La finanza pubblica italiana” (Italian public finance) for 2021. The two economists compare the paths that should be followed by applying the current rule and the one proposed by the reform. In the first case, very high primary balances would be required – above 4% from 2023 to 2027, which would then gradually decrease to about 2.5% in 2036; in the second case, primary balances should be low in the first years, but already from 2027 they should reach about 3.5% to reach a peak of almost 5% in 2033 and slightly less in the following years. One of those cures that brings to mind the old joke: “The operation was successful but the patient died”.

A reform proposal that apparently moves along a different plane has been drawn up by Olivier Blanchard (the former chief economist of the IMF, now at the Peterson Institute), Alvaro Leandro (Caixa Bank) and Jeromin Zettelmeyer (IMF). Here, in fact, the logic changes: no longer rules expressed in numbers and percentages to be respected, but qualitative prescriptions, “standards”, “that leave room for judgement together with a process to decide whether the standards are respected”. At the heart of this process would be country-specific assessments, using a stochastic debt sustainability analysis methodology, led by the European Commission. Breaches of the standard should be judged by an independent institution, such as the ECJ (or a specialised chamber), rather than the European Council.”

Now, apart from the slippery slope of assuming yet another “independent authority”, the concept is to rely no longer on fixed rules, which are “stupid” (Romano Prodi dixit), because as fixed they cannot take into account the mutability and complexity of situations, but on a decision-making process in which the Council, which is currently the highest political body in the Union, would have the last word. This is certainly a step forward, but the devil that has been thrown out the door is quickly back in the window. The basis for the Council’s decisions should be debt sustainability assessments determined with “a stochastic analysis methodology”. Once again, the supposed objectivity of an economic analysis that in any case requires estimates and forecasts – estimates and forecasts that have done nothing but produce wrong results for years – would be decisive. Debt sustainability is not an objective fact, it depends very much on political choices on how much to tax and how much to spend, and it also depends on which economic policy is chosen. And, given the structure of the Union, on what degree of freedom there is in the choice of policies to pursue.

In any case, the reform will take place, and for those who think that things should change in Europe, there is a task ahead that can be summarised in two main strands.

A battle of principles. It is not possible that the main objectives of the Union, those that the rules should achieve, are to control inflation and reduce public debt. These may be collateral objectives, which proper management of economic policy certainly cannot overlook. But there is no point in continually checking the functioning of the car without deciding where you want to go, or, in other words, making sure it works and leaving the destination to chance, even if you say it should have certain characteristics. Metaphorically speaking, even if the economy – as measured by indicators that are also not neutral – is booming, but a large proportion of citizens cannot live well, we must ask ourselves what is wrong.

A battle on methods. Enough with the use of unobservable parameters, which depend on assumptions and estimates that have almost always proved to be unreliable and which can lead to decisions that not only do not solve the problem, but cause discomfort and suffering (the Greek case is a case in point). The aforementioned Robin Brooks, for example, has proposed using the employment rate as the main parameter. But given the ideas rooted in Germany and the Nordic countries, one can also think of variables relating to public accounts. To give a crude example, the allowed budget deficit could be set on the basis of the change in GDP in the previous year: the more negative this was, the greater the fiscal stimulus allowed, regardless of the size of the deficit (and debt). Another important aspect is the control not only of deficits, but also of balance surpluses, which were already foreseen in the Macroeconomic Imbalances Procedure but, especially as regards surpluses, never enforced. Yet this is a variable of great importance for the economic balance of the Union. But just as Keynes’ proposal at Bretton Woods was rejected by the United States, whose balance was then in surplus, so in Europe the rule – which is asymmetrical because it allows a 4% deficit and a 6% surplus – has not been applied because it is Germany (and its satellite Holland) that is in surplus. We could go on, but here we just wanted to draw attention to the problem.

The pandemic has upset the system of European rules devised thirty years ago, in a world completely different from today’s and on the basis of economic theories whose inadequacy has been demonstrated by history. Decisions were taken that were unthinkable until the day before. Suspension of the budgetary rules and the ban on state aid; a (modest) increase in the European budget, which had been under discussion for over a year; economic solidarity between states (also modest, but excluded by the Treaties); substantial financing of states by the ECB (also explicitly prohibited); the first embryo of Eurobonds. Despite the admittedly not enormous size of many of these initiatives, it would seem that the much hoped-for change of course has begun. But there are negative signs, such as the reform of the EMF that has been approved and the proposal to change the Stability Pact. There is a real possibility that, once the emergency is over, those who want to return to the past will prevail.

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