Angela Merkel wants to criminalize Keynesianism. She’s proposing a fiscal union for the euro zone in which Brussels imposes penalties on governments which borrow too much. There are three ways to read this – and markets can’t decide which. It is either irrelevant, dangerous, or the start of a genuine solution to the crisis.
The reason to think it irrelevant is that we’ve been here before. The Maastricht criteria for entry into the euro and the Stability and Growth Pact were both intended to cap national government borrowing. They did not do so, because the penalties for excess borrowing – exclusion from the euro or fines – were not applied. If fiscal union is to be anything other than a squib, the punishment for exceeding the borrowing limits will have to be more credible. Ms Merkel wants automatic sanctions, but it’s not clear the rest of the euro area will agree to this.
But what if she does get her way and borrowing is effectively limited? Herein lies the danger. Such a plan would, as Wolfgang Munchau says, would make the euro “an austerity club”. And such austerity might not much improve the market’s confidence in southern European debt. As Greek, Italian and – arguably – UK experience shows, fiscal austerity alone cannot greatly reduce borrowing because, in weakening the economy, it depresses tax revenues. Bond markets might take fright at this. Dario Perkins at Lombard Street Research says it would leave us with a stability and growth pact with neither growth not stability.
How, then, can fiscal union solve the crisis? It’s because it is not a stand-alone proposal. Instead, it will – it is hoped – become part of a package.
First, if the ECB knows that there’ll be limits upon government borrowing, it might drop its opposition to buying government bonds, in the knowledge that doing so does not represent a blank cheque. ECB President Mario Draghi hinted at this on Friday when he said: “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.” Martin Lowy at Seeking Alpha says this could be the “saving and sustaining of the euro.” Charles Wyplosz of the Graduate Institute in Geneva agrees, saying that – having tried the alternatives - “governments and the ECB are focusing their attention on the necessary steps.”
Secondly – and perhaps more optimistically – centrally-imposed fiscal discipline might allow the Germans to drop their hostility to the idea of Eurobonds (a euro-wide guarantee of all euro government’s debt). At the moment, Germans are loath to underwrite southern European debt for fear that if they do so those governments will borrow like billi-o in the knowledge that someone else will bear the cost. Credible limits on government borrowing would calm Germans’ fears on this point. However, Mr Perkins warns that it is “fanciful” to expect this.
Now, a saving of the euro - a fiscal compact which allows the ECB to use its unlimited power to print money to buy government debt – would probably not be sufficient to prevent a euro area recession, which is probably under way already. But it would give a big lift to equities because it would reduce the chance of disaster – a break-up of the euro in which banks suffer massive losses on their holdings of southern European debt. In this sense, the stakes are high.
But even if we get such a happy outcome, a big question remains: how will Italy, and other PIGS, be able to grow over the long-term without fiscal stimuli? The hope is that supply-side reform – less labour protection and the like – will somehow improve trend growth. I fear this might be a little optimistic. If so, tensions within the euro area, between a tolerably-growing north and a stagnant south will eventually re-emerge.