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Is a Balance Budget Amandment the Solution for the Euro?

August 17, 2011

Yesterday, Chancellor Merkel and President Sarkozy met in Paris to discuss the future of the euro (NPR’s report is available here).  The leaders both agreed that they were opposed to the idea of issuing “euro bonds,” which had received support from George Soros.  As our post “Credit Ratings and the Euro,” these euro bonds would be unacceptable to the average German, since they would probably lead to higher interest rates on German bonds and the rating for these new bonds might be below Germany’s current AAA.  Instead, the leaders pushed for leaders of the Eurozone to regularly meet and that countries using the euro should enact constitutional amendments requiring balanced budgets by the summer of 2012.  While this might be a good idea in principle, would it work?

The first hurdle that this plan would need to overcome is getting at 17 Eurozone members to agree to this “golden rule.”  Austria has already stated their opposition.  Then, even if everyone agreed and this new rule went into effect, how would it be enforced?  By amending national constitutions, the assumption would be that each of the member states would have some sort of mechanism to ensure that a government follows their own constitution.  Member states had already agreed to limit their spending, only to renege later.  The Masstricht Treaty, which every member of the Eurozone signed in 1992, required that they would keep their annual government deficit below 3% of GDP and government debt would not exceed 60%.  If a country was in breach of these rules, they were to pay large fines to the EU.  Unfortunately for the euro, as figure 1 shows, by 2002 (i.e. three years after the introduction of the euro), both France and Germany were in breach of the rules.  The result was that the rules were modefied. This is not a good precedent for a future balance budget amendment.

 

Source: Eurostat

Secondly, does a balanced budget amandement make sense economically?  Figure 1 also shows that France has never run a government surplus while using the euro, so cuts would have to be made to government spending to balance budget, and this could hurt economic growth in France.  “Exhibit B” would be Italy, which is actually running a primary surplus right now (i.e. government spending excluding interest payments on its debt is actually less than government revenue), yet the country’s finances are now receiving a lot of scrutiny.  Thus, balancing budgets might not necessarily calm investors’ nerves in the short term if a country also has a large debt (in the long term, the debt should be shrnking under a balanced budget amandement, fixing the problem).

A balanced-budget amandement also limits a government’s options during an economic downturn.  Ireland had done a very good job of running a government surplus during the good years (figure 2). However, when its property bubble burst, putting the future of its banking sector at risk, the government through that it could use government borrowing to solve its problems.  While this decision may appear to have been foolhardy in retrospect, at least the government had an option.  A balanced budget amendment would severly limit the government’s ability to run Keynesian economics during a recession.

Source: Eurostat

 

 

As pundits examine yesterday’s Franco-German proposal, there will no doubt be comparisions to the United States.  Many American states, including Indiana, have balanced budget amandements.  However, these states also have the Federal Government (which can run deficits) to help them out in time of need, and states have all received more Federal stimulus dollars during the recession.  This is the heart of the European debt crisis, since the EU’s budget is tiny and it cannot help out a government in need—hence to origianl Maastricht rules in the first place.

Finally, Vanity Fair published an article this month where Micheal Lewis argued that the cause of the economic crisis and Germany’s response comes down to their belief that people follow rules.  Thus, the German idea of a balance budget rule to solve the euro’s woes.  However, it is not clear that more rules, at least of this type, will be the solution.

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