The SGP ramifications of the Greek Crisis

I was just at a conference of Europeanists in Montreal a couple of weeks ago, and although many of them didn't show because of the lack of transatlantic flights due to the Icelandic volcano ash clouds, there were enough delegates to get a good guage on what Europeanists are thinking about in terms of the future of the European Union and the euro and the ongoing Greek crisis.

The main ramification that I got from chatting with other delegates is that the Stability and Growth Pact (SGP) is essentially dead, with the Greek situation putting the final nail in the coffin!!  The SGP was originally a German idea back in 1997, which was meant to allay German fears that they were giving up their beloved Deutschmark for something not as robust and that they had less control over.  The main condition in the SGP (which was actually just a continuation of the main Maastricht criteria for fiscal policy) was the budget deficit criteria which specifies that member states need to keep their government budget deficits below 3% of GDP. 

Academics like Willem Buiter had already criticized the budget deficit criteria as a little meaningless, not just because it was seemingly an arbitrary number, but also because it is usually debt that matters for fiscal sustainability rather than deficits.  For example you can have a very low debt and then have some kind of event where you need to stimulate your economy big time - Finland went through something like this in the 1990s, and the US is clearly going through something similar right now - so that your budget deficit balloons during that period.  To put this more simply, it is like focusing on the most recent additions to your credit card debt (if you have any!), rather than focusing on the total that you owe.  Clearly the total is the most important figure, not what you've just added to the total. 

The SGP then specified that if you ran a deficit above 3% you would attraction the attention of the European Commission and then a complex process would begin such that you would have time to put your house in order and if you didn't you'd first be sanctioned and then fined.  There were let-outs for recessions and other uncontrollable events, but essentially during normal times a member state's budget deficit was supposed to be under 3% of GDP.

The way the SGP was supposed to work was that governments would report their deficits and debts to the Commission and then they would decide what the situation was, and then the Commission would prepare a report and if any action was needed would pass this on to the European Council for a decision - and some of these decisions were supposed to be almost automatic.  Back in 2004 both France and Germany were found to be violating the 3% limit and the European Council decided to do nothing, violating the spirit of the SGP and prompting some soul-searching on what kind of conditions should allow a member state to run deficits that were greater than 3%.  The so-called SGP II was launched, which was softer on member states when they ran deficits and also had a greater focus on debt, but essentially it was the same "monster", wrapped up in a little more sensible clothing.  But apart from the aforementioned problems, there were other fatal flaws with it ( - described in many of my earlier papers on this topic). 

First, the EU member states did the public accounting to construct the measures needed for the SGP - so as Greek did, you could easily "fix" the figures and the Commission would be none the wiser.  It seems to me that if the SGP was to be taken seriously the Commission should at least have had a representative working in every finance ministry in the euro area.  They didn't.  When the IMF needs to evaluate what is going in a country, a team is sent out - and obviously the veracity of the figures is evaluated at the same time.  There is no Commssion equivalent.

Second, it was all stick and no carrot.  Where was the reward for being good?  With the IMF if you do what they say you get money...money in the form of a loan that you desperately need.  With the European Commission you got nothing more than you otherwise likely would get - so there is basically no incentive to be good.

Third, even if the SGP was mostly stick, the stick was hidden from view, as there was a tacit acknowledgement that the penalties would (likely) never be used - to fine a member state that was already running a deficit seems a little counterintuitive - shouldn't the rest of the EU be helping them, not punishing them?

Fourth, having the SGP gave the financial markets more "comfort" than they should have had, as it probably hindered them from properly evaluating the risk of default from any one member state.  So when there was a realization that the Greek situation was much worse than thought, the yield on Greek bonds really took off. 

So the Greek situation has really broken the SGP - and good riddance to it in my opinion.  Monitoring member states and reporting back on their fiscal situation seems like a sensible idea, but it has to be constructed in a way that makes sense and the SGP never made a lot of sense to me, not only in its essential ingredients, but also in the way it was implemented.

Soros on the euro - but what about the other flaws??

On Fareed Zakaria's CNN show this week we had the privilege to hear the views of the billionaire financier George Soros (see http://www.cnn.com/video/#/video/podcasts/fareedzakaria/site/2010/02/28/gps.podcast.02.28.cnn) on a variety of issues.  What caught my ear though was his comment that the euro was "fundamentally flawed" as the European Union doesn't have a Treasury to enble fiscal transfers to occur, so as to offset the asymmetric shocks ( - unexpected events that occur which affect one member state much more than the others).  This is of course just one of the basic problems with the euro's architecture, and Soros is right in pointing out that this is probably the most obvious flaw to think about in the light of the Greek debacle.

But what really got my attention was that Soros then went on to say that "either Europe takes the steps to make up for it's institutional deficiency or it may not survive" ( - I assume he means the euro here).  So I want to add a little to what Soros said, by i) talking about other things that might be wrong with the euro and ii) by thinking a little about what form these institutional measures might take. i) I'll do today and I'll leave ii) to tomorrow.

So let's start with the other flaws. 

First, the "Maastricht criteria".  These were the hurdles which member states had to negotiate to become a member of the euro club.  The rewards for negotiating these hurdles were significant, as it meant lower interest rates, added credibility internationally, and to be blunt, a seat at the heart of the European integration project. It's like the local neighborhood clubhouse - who wouldn't want to become a member unless they didn't like their neighbors too much (for example the UK).  So if you have to fulfill certain criteria (like having a certain minimum salary - to continue our clubhouse analogy) you would maybe manipulate things a little to get in.  The Commission was aware of this, particularly when certain member states asked if they could sell gold to lower their budget deficits, and so the Commission made up quite strict rules about how to measure budget deficits, which all the "northern" (read less corrupt and less politically manipulated) member states duly abided by.  Southern (read generally more corrupt and more politically manipulated) member states of course stayed relatively silent on this, and now we see why.  Countries like Italy got in because of statistical anomalies and Greece actually didn't get in first time around, so realized what it needed to do the second time around.  The main point here is that the Maastricht criteria were flawed to begin with - the statistics which were used to base the entry decision on were produced by each individual member state - so they depended on the quality and honesty of the statisticians and politicians involved in the production of the stats.  The result is that if you have flawed entry criteria you're going to get problems at some point along the way as members don't live up to expectations.

Second, "surveillance".  The European Commission made a big song and dance about member state surveillance back in 2004 when the Stability and Growth pact (or SGP - see http://europa.eu/scadplus/glossary/stability_growth_pact_en.htm) was revised to soften the actual criteria (because Germany and France had run up against the deficit limits that were supposed to trigger sanctions).  Clearly they haven't worked, and not because it wasn't a good idea, but because the Commission can only monitor what is produced by the member states.  Once again its the member states that produce the statistics, or manipulates the statistics for political purposes, so this wouldn't be detected by the "surveillance" process. 

Third, and probably most importantly, the ECB's treatment of public debt in monetary transactions.  There is no mechanism whereby the ECB can basically "grade" the member states on their fiscal policy. Now of course this doesn't happen in the US, and in the case of Canada there are provisions for it to happen (a line item in the Bank of Canada's balance sheet) but it has never happened.  The reason is that both Canada and the US (and I presume other monetary unions) have federal debt issuing capabilities.  So when the Federal Reserve does open market operations it uses US federal bonds and notes, but in the case of the ECB, it has to use member state bonds because there is no EU federal debt.  So the rules are that the ECB cannot discriminate between different member state bonds.  So this means that the member states do not feel the fury of the markets because there is always a buyer (and therefore a "backstop") for Greek bonds in the form of the ECB.  And from the individual investor perspective this clearly poses an adverse selection problem.  If I'm holding German, French and Greek bonds and the ECB is looking to buy euro-denominated bonds for its monetary policy transactions, which am I going to sell?  It's a no-brainer!! 

OK, so given that the euro design is flawed, what should happen now?  More on this next time in part II!!