360° Analysis

Euro Area Fiscal Compact


January 01, 2012 20:20 EDT
In this article, John Bruton, former Taoiseach of Ireland and former EU Ambassador to the US, examines the practicality of the constitutional ban on structural deficits in excess of 0.5% under the EU fiscal compact.

The key novelty in the “fiscal compact,” announced at the EU Summit on December 9, was an agreement that each country in the euro zone ought to agree that:

1. Its annual structural deficit shall not exceed 0.5% of GDP.

2. This rule shall be introduced into its legal system at the “constitutional or equivalent level.”

This 0.5% structural provision, to be included in national constitutions, is new and has never been enacted before.  It is entirely separate from the Excessive Deficit Procedure, under Article 126 of the existing EU Treaties, which was agreed to long ago and provides for fines to be imposed on countries if their deficits exceed 3%.  The new provision has been strengthened by proposals agreed to before the summit that make it more difficult for countries that break the 0.5% provision to avoid fines through political lobbying.  These proposals have taken effect in the week following the summit.

The provision is in addition to other changes that will require no treaty or constitutional change.  These changes will penalise countries for excessive debts and excessive deficits, further requiring those countries to reduce their debts progressively by a fixed amount each year.

Only a close examination can determine whether this new provision will be effective, and if it is clear in its meaning to be inserted into the constitutions of 17 countries. Its inclusion in the constitution of Ireland or any other of the 16 countries will need a lot of work.

In theory, the term “structural deficit” means the actual deficit recalculated to account for the point the economy is at in its “economic cycle.”

For example, if the economy is in the midst of a temporary boom, tax revenues would be temporarily boosted, and what appears as a budget surplus might conceal what is actually a budget deficit once the economy contracts to its normal state.

On the other hand, if the economy is in a temporary slump, revenues might fall to an exaggerated degree. A budget deficit might be purely transient and would disappear on its own accord once the economy returns to normal levels of activity. In that situation, a country with a deficit in day-to-day money may actually have a “structural surplus.”

The “structural deficit” or “structural surplus” is the deficit or surplus that would apply in normal times - when the economy is in its normal state and not in the midst of a temporary downswing or a temporary upswing.  This works fine in theory.  In reality, calculating “normal” economic conditions and “normal” growth rates is messy and highly subjective.  Indeed, the key question here is whether “normal” economic times ever exist.  The theory of the structural deficit assumes that there is some sort of predictable cycle in economic activity, whose movements can be foreseen.  The truth, however, is that in an economy open to the rest of the world, like Ireland’s, economic activity and thus tax revenue are influenced by entirely unpredictable global events.

An unpredictable event could be a technological breakthrough, such as new use of the Internet or the discovery of a new pharmaceutical, which releases unforeseen productive capacity in Ireland.  On the other hand, the event could be an earthquake, a terrorist attack, or an epidemic that destroys markets that are otherwise abundant and dynamic.  Such an unpredictable event could make the assumptions used to calculate the structural deficit utterly irrelevant.

Curiously, under the proposal put forward on December 9, the final say about the structural deficit will lie not with economists but with judges.  A citizen could sue the government for passing a budget with a structural deficit in excess of 0.5% of the GDP for that year.  This means that judges would find themselves in the position of deciding whether the Irish Dail or any other national parliament had acted constitutionally in passing the budget.

To take Irish example, the Supreme Court would have to determine where the country lies in its economic cycle.  It would have to decide when the cycle had begun, how much longer it would persist, and what the “normal” level of economic activity would be when the economic cycle had run its course.  These are not legal matters of the kind that Supreme Court judges are normally called upon to decide.

They involve economic assumptions and calculations that are highly arbitrary and deeply contentious, on which economists, who might have studied the issue all their lives, would be deeply divided.   Furthermore, there is a possibility that as soon as the Supreme Court would decide the “normal” level of economic activity, some unpredictable event might come along and require the calculation of a new “normal” level.  There is also the question of what sanctions the Supreme Court could impose on the government and the Dail if the structural budget deficit is deemed to exceed 0.5% of GDP.

Some countries, like France, have relatively soft sanctions for breaching the constitution, while other countries, like Ireland, immediately strike down an unconstitutional law as null and void. What would happen to a budget that was deemed to be unconstitutional because it had a structural deficit above 0.5% of GDP? This critical question needs an answer.

When is this new arrangement coming into force?

If the provision is intended to influence the markets, the date cannot be pushed too far into the future.  At the same time, we are a long way off from having a structural deficit anywhere that is as low as 0.5% of the GDP in most of the EU.  According to Deutsche Bank, the structural deficit of the Euro area as a whole stood at 3.2% in 2011.  According to NCB, even if it follows the EU/IMF plan to the letter, Ireland’s structural deficit will still be at 3.7% in 2015.  In these circumstances, the purpose of writing a figure of 0.5% into the constitution is highly questionable.

Voters in the inevitable referendum in Ireland might well agree that a 0.5% structural deficit is indeed a worthy aim, and something that is a worthwhile political goal.  They might, however, have real difficulty in agreeing to turn something so difficult to calculate and monitor into a rigid constitutional rule.  Such a rule would bring the Supreme Court into the heart of political decision-making, thereby weakening the principle of the separation of powers that underpins the Irish political system.

The next summit is at the end of January and the Taoiseach and Ministers along with other national governments have a number of extraordinarily difficult issues to wrestle with till then.

The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.


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