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Stability Pact




Wolfgang Münchau

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"Imbalances can last a long time, but they do not last for ever"

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It could be that future generations of German politicians find ingenious ways around the balanced budget law.
Or that they find a two-thirds majority to overturn it.
Or that Mr Sarkozy or his successors follow Germany into a future of austerity.
But as long as one of those three events fails to happen, Germany may discover that unilateral fiscal rigour in a monetary union could prove extremely costly.
For the sustainability of the euro, you surely do not want to get into a position where a large member state has a rational economic reason to quit.
So if Germany and France really do what they both promise, you may as well start the egg timer.

Wolfgang Münchau, Financial Times June 28 2009

I never expected a message of austerity to emerge from the Palace of Versailles, where Nicolas Sarkozy outlined his economic strategy.
He left no doubt that he is not prepared to follow Angela Merkel in the direction of a balanced budget.
He distinguished between “good” and “bad” government deficits, a good deficit is cyclical, a bad deficit structural

One can have endless debates about the relative benefits of Germany’s legalistic approach or Mr Sarkozy’s alternative version.
Whatever side of the debate you support, you will probably agree that it is not a good idea for the two largest members of the eurozone to move in opposite directions.
In fact, it could prove highly destabilising to the eurozone.

Germany, as I argued last week, is heading in the direction of a zero level of government debt in the long run as a consequence of a new constitutional balanced-budget law.
It is perhaps not intuitive that a balanced budget, pursued indefinitely, would eventually lead to a complete eradication of public debt. But this is what will happen.

In fact, Germany’s new law imposes an upper deficit ceiling of 0.35 per cent of gross domestic product over the economic cycle. But remember this is a ceiling. There is no floor. If the cyclically adjusted deficit came in exactly at that ceiling, year after year, and assuming a nominal rate of output growth of 4 per cent, this would stabilise Germany’s debt-to-GDP ratio at just under 10 per cent. So if this constitutional law sticks, Germany’s debt-to-GDP ratio will settle somewhere between zero and 10 per cent in the long run.

Now, Germany is a country with a large current account surplus, or excess of domestic savings over domestic investments – 6.6 per cent of GDP in 2008 and 7.6 per cent the year before. It is no surprise therefore that German banks have been hit so heavily by the securitisation crisis. They had to channel masses of surplus savings abroad. In the event, they bought US subprime mortgages and their derivative products.

They will not repeat the same mistake, but they will still be facing a problem. If Germany’s national debt converges towards zero, Germany’s surplus savers will have to invest huge amounts of their savings outside the country, since the supply of German government bonds will diminish over time as the outstanding stock of debt is depleted.

Now this is where Mr Sarkozy’s bad deficits come in. Most German savers, especially pension funds, will want to invest in euro-denominated government debt, which, for practical purposes in this scenario, means French debt, because no other domestic European bond market is sufficiently large and mature. As a result France may enjoy a version of America’s exorbitant privilege.

If Germany unilaterally goes down the road of deficit reduction, and if France unilaterally goes the opposite way, the result will be a serious imbalance. France will find it progressively easy to finance its public sector deficit, as German savers have no choice but to buy French debt instruments. They will get trapped in French debt, just as the Chinese got trapped in US debt.

This means that Germany will suffer two successive blows. The first is a sacrifice of economic growth as a result of the pro-cyclical policies needed to do away with the deficits for ever. We got a taste of that last week, when Klaus Zimmermann, president of the German Institute for Economic Research, advocated an increase in value added tax from 19 to 25 per cent. Such action would obviously be disastrous for economic growth. It would throw Germany into a full-scale depression. But he is right in a narrow technical sense. If Germany is hell-bent on eliminating its structural deficit by 2016, some drastic measures are inevitable. Ms Merkel has said she will not raise VAT, but she will either have to raise other taxes or cut spending. Politically, the first will be easier than the second.

Once budgetary balance is achieved, at huge economic cost, German savers will then suffer the second blow in the form of poor returns on investment, as their surplus savings will be financing Mr Sarkozy’s good, bad and ugly economic policies.

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Germans are amazed at global reaction to their fiscal proposals
FT Deutschland had an interesting culture shock article in which it quotes several economists as saying that
Germany’s debt rule, if applied to the whole of the eurozone, is much more likely to result in investor panic than solve the problem. This is one of the great debate mismatches at present, as the Germany are reducing the eurozone’s entire difficulties to fiscal indiscipline and speculative attacks,
while many professional economists believe that the problems are the result of internal imbalances that got out of control.
Eurointelligence 20 may 2010

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A decision was taken recently in Berlin to introduce a balanced-budget law in the German constitution.
It was a hugely important decision.
From 2016, it will be illegal for the federal government to run a deficit of more than 0.35 per cent of gross domestic product.
From 2020, the federal states will not be allowed to run any deficit at all.

Unlike Europe’s stability and growth pact, which was first circumvented, later softened and then ignored, this unilateral constitutional law will stick.
I would expect that for the next 20 or 30 years, deficit reduction will be the first, second and third priority of German economic policy.
Wolfgang Münchau, FT. June 21 2009

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