An External Stability Pact for Europe

BERLIN – The current economic crisis has exposed two fundamental problems in the design of the European Monetary Union. The first concerns the sustainability of public finances in a number of euro-zone member states. Second, inadequate macroeconomic policy coordination has resulted in divergences in the international competitiveness of euro-zone members, threatening the very existence of the euro.

Countries whose public finances seemed fundamentally sound as late as last year have come under severe fiscal pressure. Ireland’s government debt is expected to rise to almost 80% of GDP by 2010, whereas just a year ago the European Commission projected that Ireland’s government debt would be below 30% of GDP. Likewise, whereas Spain was expected to decrease its debt ratio, its debt-to-GDP ratio is now likely to double between 2007 and 2010, to more than 60%.

The EU’s fiscal surveillance mechanisms failed to predict these developments because they neglect a crucial variable: the dynamics of private-sector debt. Given the high economic costs of a banking crisis, governments are likely to take on the liabilities of their financial sector when a crisis hits – as recently occurred in the United Kingdom and Ireland, and in financial crises in Latin America and Asia in the 1990’s. The same is probably true when key business sectors near insolvency. A country with sound public finances can thus become a fiscal basket case practically overnight.

Given the increasingly close financial and economic linkages between euro-zone members, rising government debt in even one EMU country can have serious consequences for all members, because no member state will allow another to default. Thus, EMU members indirectly share the liability for fellow countries’ private-sector debt, which for this reason should be monitored within the EMU’s surveillance framework.

Another apparent problem is that EMU member states – at least until now – do not coordinate their economic policies effectively. Even before the crisis, this resulted in divergences in competitiveness and in the business cycle. The persistent loss in competitiveness over the past decade is one reason why the crisis is hitting some southern European EMU countries such as Spain and Italy so hard.

The inefficiency of fiscal-policy control and the lack of economic convergence are a matter of increasing concern to both the European Central Bank and euro-zone finance ministers. While no initiative for coping with these problems has been tabled so far, the issue is certain to become a matter of debate within the EMU.

One way to tackle the problems associated with government debt, as well as to improve economic policy coordination, is through a simple extension of existing rules: an “External Stability Pact” could be introduced to complement current EMU regulations. This pact would monitor current-account imbalances and penalize excessive deficits or surpluses in the external account.

Monitoring external balances can be an effective tool to measure future default risks, since sustained current-account deficits lead to a growth in net foreign debt. Moreover, there is a direct relationship between the EMU countries’ private-sector debt dynamics and their current-account imbalances within the euro zone. So long as a national government is not running more than a modest deficit, a current-account deficit reflects the private sector’s borrowing from abroad (or the sale of previously accumulated foreign assets). If the current-account balance is assessed together with the fiscal position, it becomes possible to draw conclusions about risky debt trends within the private sector.

The mathematics of debt dynamics suggest that no euro-zone country should have a current-account imbalance, whether a deficit or a surplus, of more than 3% of GDP. Exceptions could be granted for countries with large inflows of foreign direct investment in greenfield projects. The rule should apply both to debtor and creditor countries. After all, payment imbalances always have two sides, and the burden of adjustment should not be borne only by deficit countries.

Such a pact would oblige governments to use fiscal and wage policies as well as overall economic policy to achieve external balance. It would also lead to broader economic-policy coordination, particularly with respect to wage-setting, because governments would be compelled to use national legislation and public-sector wage settlements to influence wage policy in such a way that imbalances among euro-zone countries are reduced.

Furthermore, an External Stability Pact would oblige governments to take into account the consequences for other member states when designing national economic reforms. If a “surplus country” such as Germany wanted to lower non-wage labor costs and increase value-added tax in order to boost its competitiveness, it would simultaneously have to adopt an expansive fiscal policy to compensate for the negative effects on its partners’ foreign trade.

Within the framework of these rules, individual countries would retain the authority to design their policies. The Spanish government, for example, could have met Spain’s building boom and foreign-trade deficit with tax increases or by urging domestic wage restraint. Alternatively, it could have intervened by instituting planning regulations or imposing limits on mortgage loans.

An External Stability Pact would not only detect risks to fiscal stability early on; it would also help make a reality of a fundamental principle of EU law, namely that member states finally treat economic policy as a “common interest.

By Sebastian Dullien and Daniela Schwarzer
Sebastian Dullien is Professor for International Economics at the University of Applied Sciences HTW in Berlin. Daniela Schwarzer is Head of the Research Unit “EU-integration” at the Stiftung Wissenschaft und Politik (SWP), the German Institute for International and Security Affairs, in Berlin.

Post-Crisis World Institute