Can the fiscal compact solve the euro crisis?
On December 9, the European Summit will be presented with plans agreed between Germany and France for a new fiscal compact. The thinking underlying these plans is neatly articulated by Mario Draghi, president of the European Central Bank, in his statement to the European Parliament on December 1. The central problem is the credibility of the European fiscal governance, which is clearly not commensurate with the requirements of monetary union. A new framework of fiscal surveillance and sanctions is thus needed, which will ensure the avoidance of excessive public indebtedness in the future.
Draghi then poses the obvious question whether this longer-term arrangement would be enough to stabilize markets today. ?Our answer is that it is definitely the most important element to start restoring credibility. Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.?
There are a number of problems with Draghi?s answer. Firstly, the assertion that ?confidence works backwards?, so that trust-building in the short term is dependent on confidence in the long term, is at least paradoxical. Apart from the certainty that, as Keynes famously stated, ?in the long-run we are all dead?, there is practically nothing in the long term about which we can have more confidence than in the short term. After all, this is the main reason government bonds of longer duration have normally higher interest rates than similar ones of shorter duration. It seems more reasonable to argue the exact contrary to Draghi?s assertion: confidence is not built on long run promises or vision; it is rather built on a sustained succession of short run results.
A second problem is the argument that ?the sequencing matters? and the fiscal compact should come first. Nevertheless, it is admitted that this may be only a start in restoring credibility and ?other elements might follow?. But if this the case, why don?t they all come at once? Surely, a broadside attack can be more effective in restoring confidence and resolving the crisis than a piecemeal approach. To be more specific, an end to the crisis becomes much more likely if the fiscal compact is accompanied by the European Central Bank being allowed to act as a lender of last resort to both governments and banks.
But the most serious problem with Draghi?s answer is the belief that on its own a fiscal compact, which imposes contractionary fiscal policies and leads to recession, is sufficient in restoring confidence. More likely than not, this only creates a confident expectation of a protracted period of recession. Such an expectation increases the perceived risk in financial markets and weakens them further. Thus, instead of resolving the euro crisis, the fiscal compact risks worsening it by pushing the European economy into a deep recession.
In conclusion, the fiscal compact must be accompanied right from the start by the European Central Bank?s right and declared intention to lend to governments (possibly through the IMF), if the euro crisis is to be resolved.
*Thanos Skouras is Professor Emeritus, Athens University of Economics and Business