A fiscal straitjacket

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DISCIPLINE is often a good thing, but not when taken to extremes. Just as spendthrifts who cut up their credit cards may regret it on some rainy day, so European governments may come to rue their decision to sign up to the “growth and stability pact”, which limits euro members’ budget deficits to 3% of GDP and threatens any country that exceeds this figure with heavy fines.

The economic rationale for the stability pact is that the euro may otherwise offer member governments a free ride: they can borrow recklessly, because markets will not punish such profligacy in the belief that the European Central Bank would bail out any government that got into trouble. As a result, all euro members would pay higher interest rates.

But this rationale does not stand up. However much Italy, say, borrows from international capital markets, it is unlikely to raise euro interest rates significantly. Mexico’s huge dollar borrowing in 1995-96 did not raise American interest rates. Moreover, the ECB is expressly barred from bailing out national governments, so any that borrow excessively will have to pay an interest-rate premium, just as debt-laden companies do.

Surely, though, any discipline on governments’ temptation to borrow and spend, even if misconceived, is welcome? Only up to a point. When a country goes into recession, its public finances worsen, since tax revenues fall and social spending rises. That is a good thing, because it acts as a countercyclical force. To give growth a further boost, governments may even need to loosen fiscal policy further. When they are in the euro, that fiscal flexibility may become even more necessary, because they will no longer be able to cut interest rates or devalue.

Yet the stability pact could perversely force a country whose growth slows down when its budget deficit is already near 3% of GDP—as may easily happen soon in Italy—to tighten policy just when it should be loosening. Think how much worse Japan’s problems in the 1990s would have been if it had been stopped from running a large budget deficit, currently 6% of GDP.

What about the temporary let-out clauses allowed in the pact? The trouble is that they apply only if a country is in deep recession, not if its growth has merely come to a stop. The best thing about the pact is not its let-out clauses, but the fact that the fines it envisages are not automatic: they require majority approval among euro members, and they are not paid for at least two years. It is hard to believe that France would ever submit to the indignity of an EU fine, whatever the pact says.