De-stabilisng the Stability Pact

The Malta Independent 

France and Germany are offending the Stability and Growth Pact (SGP) underpinning the Euro monetary union for 12 EU states. In effect France and Germany are running budget deficits beyond what is expected of them under the SGP and rather than make internal adjustments to honour their common currency commitments they are seeking to de-stabilise it. In polite diplomatic jargon they are demanding for flexible interpretation of the SGP.

It is easy to criticise France and Germany and insist that they adhere to the rules which have been enforced with full vigour on smaller EU members. Portugal is undergoing severe fiscal restraint to bring itself within the pact and smaller EU countries have exercised such restraint to ensure that they stay within the set rules. Why should the rules which apply rigorously for the smaller country members but be applied leniently with the big members? The Commission supports a uniform approach and has this week publicly reprimanded France and forwarded its report to the Council of Ministers as contemplated in article 104 of the Maastricht Treaty.

Fairness apart, it would however be unrealistic to expect the Euro area to achieve comparable economic growth with that of the US if its two largest economies, France and Germany, are forced by the SGP to apply the economic brakes on their economies when these are registering anaemic growth if at all. The smaller countries, like Ireland, Austria, Belgium, Netherlands, Finland and Greece cannot on their own deliver the necessary regional growth if France, Germany and Italy fail to notch up their growth` under the adjustment conditions imposed by the SGP.

The European Central Bank exiting president, Dutchman Duisenberg, is right in arguing that France and Germany did not save for the rainy day when the going was good. Germany is still paying the cost of the integration of its former eastern part whereas France lavished in solving problems by working a shorter week, a measure which has seriously prejudiced its international competitiveness. But the clock cannot be put back and I don`t think that the Euro area urgent growth problems can be solved by the rigid application of the SGP on its two or three largest economies.

Reality is that when the SGP was devised way back in 1992 its conditions were set to suit a very different scenario from the one we have today. The threat to Growth was then perceived to be excessive inflation which was sourced from excessive budget deficits. So the way the SGP was drafted, principally by the Germans, was to ensure that the risk of inflation is controlled by putting strict conditions on the size of the budget deficit assuming that once inflation is controlled sustainable growth would automatically follow.

The situation today is very different. In spite of excessive budget deficits there is no risk of inflation which is hitting record lows well within the ECB`s target range. But low inflation is not delivering growth and in old-fashion Keynesian style the US is pump-priming the economy by running huge budget deficit at a time of record low interest rates.

Is it wise for Euro countries continue to invoke strict application of the terms and conditions of the SGP written under very different conditions and aimed to address very different circumstances than those prevailing today, whilst the US goes for growth free from the restrictions of strict monetary unions rules regarding debt and deficit  ?

  The argument is made that any flexible interpretation or outright revision of the SGP would loosen international investors` faith in the Euro. This is not something that in normal circumstances should be taken lightly. But these are not normal circumstances. The Euro is hardening too rapidly on the foreign exchange market and the ECB will have to do something about it to retain international competitiveness. It could of course reduce Euro interest rates further and bring them down to US levels and below the actual inflation rates. But it could also, and may be more effectively, re-write the SGP rules to re-balance the obligation of Growth with the obligation of Stability as it is clear that stability in fiscal positions is no longer delivering the desired levels of growth. If this could force down the Euro a little bit from its current strength then so be it.

With a Frenchman about to take over the ECB may be France stands a better chance of making the Council of Ministers and the Commission see the light. It will definitely find backing from Germany and Italy, second line offenders, and could overcome the objections of the smaller countries who rightly argue that they are made to honour the rules whilst the rules are made to honour the big countries. That`s life!

Benchmarking with Peers

The Malta Independent on Sunday 

  

There is no doubt about it. We have some problems which need to be addressed without further delay.

The Prime Minister admitted as much during his independence speech though he shied away from stating the obvious that his government carries primary responsibility for the creation of these problems.

We should be happy for the small mercy of having achieved convergence of opinion at least on the fact that problems do exist. Gone are the pre-election days of liberal assurances that everything was fine and under control and that government finances were on a sound footing, that the very accession to the EU will generate an impulse of investment to re-generate the economy and deliver sustainable growth at a rate that would permit a fast catch-up with the EU average.

Acknowledging of problems is a necessary first step. On its own, however, it does nothing to provide any solution although it helps to raise awareness of the need to come up with solutions. The next thing we should do is ask ourselves, just about how big is the problem? And there can be no absolute answers to this, only relative ones in comparison with the situation prevailing at our competitors which in this case are the other nine countries acceding to EU membership next year and who will be playing with the same rules and regulations to try to push their fortunes closer to the EU average.

	Fiscal Def	Fiscal Dbt	Bank Assets	Stock Market Capitalisation	Inflation
	/gdp %	,/gdp %	/GDP %	/gdp%	CPI 2002
Country	2002	2002	2002	Aug-03
Cyprus	2.9%	56.6%	290.0%	47.0%	3.6%
Czech	7.3%	20.0%	91.0%	18.0%	2.4%
Estonia	surp1.2%	5.8%	101.0%	38.0%	3.6%
Hungary	9.9%	53.3%	106.0%	17.0%	5.3%
Latvia	2.5%	15.2%	79.0%	11.0%	1.9%
Lithuania	1.2%	23.6%	37.0%	17.0%	0.3%
Malta	5.2%	62.5%	298.0%	35.0%	2.2%
Poland	5.7%	48.8%	72.0%	16.0%	1.9%
Slovakia	5.5%	38.5%	106.0%	13.0%	3.3%
Slovenia	2.9%	28.0%	92.0%	14.0%	7.5%

Source : own research

I have prepared a table of comparison for the 10 acceding countries of five key macro-economic performance indicators. They are all in percentage terms of GDP (except inflation which is a percentage of increase of consumer prices within the economy) in order to make them more easily comparable overriding the size difference from Poland, the largest, to Malta, the smallest.

Take our fiscal deficit which last year came in at 5.2% of GDP. Bad as this may be there were four other countries performing worse than us with the extreme being Hungary with nearly 10% of GDP deficit. At the opposite virtuous extreme there is Estonia with a budget surplus of 1.2%. Rather than be concerned about the absolute level of the 2002 deficit we should be more worried by the fact the 2003 deficit is shooting up to 7% as one-offs that cushioned the 2002 outturn will not be repeated. Even more worrying is the prospect that in the absence of structural adjustment this deficit will continue to increase as we are made to finance our share of the contribution for carrying out the obligations of EU membership.

The annual deficit will take a more meaningful significance if viewed against the situation of accumulated fiscal debt. So for example Czech Republic’s 7.3% 2002 deficit is much less worrying if considered against a 20% accumulated debt position than if considered on its own. Basically the Czechs have a great capacity to incur deficit so their current high level of deficit is much more tolerable than it would be if the accumulated debt level was anywhere near the Maastricht indicator of 60%.

So the seriousness of Malta’s deficit gains added significance in the context of our chalking up the highest rate of Debt/GDP of all candidate countries. At 62.5% we are already above the EMU limit and our capacity to incur debt is getting uncomfortably narrow just as the size of the annual deficit has started growing again.

To take a wider view of things I have included a view of the ratio of Bank Assets to GDP. This is meant to assess the level of facility with which the broad economy can finance the deficit incurred. The bigger the ratio of Bank Assets to GDP the bigger is the capacity to finance the deficit within the economy without crowding out private investment finance demands and without hiking up domestic interest rates. This ratio indicates the accumulated savings of the whole population within the economy. And here we can sigh some relief. The savings culture inherited from our ancestors and the size of accumulated past savings are strong enough to give the government undeserved freedom to finance deficit on comfortably structured terms at low interest rates. Compare Lithuania who although boasting very low debt/GDP ratio has very limited capacity to finance deficits internally as they have the lowest Bank Assets/GDP ratio. It could be the result of insufficient past savings or inherent culture to keep savings outside the economy.

So whilst our fiscal problems are not to be under-estimated we should take heart that these problems are generally domestic rather than external and that we still have a large capacity to finance debt, provided we do nothing foolish to force people to use the freedom of capital to take their savings elsewhere.

The final statistics calculates the Stock Market capitalisation as a percentage of the GDP which is a good indicator of the sophistication of the financial markets and finally the level of domestic inflation. In both cases we are among the best of the breed among EU candidate countries.

The conclusion I can best draw from this analysis is that provided we do what we have to do without further delay the position should be recoverable in the medium term. If we do what needs to be done without further false compromises with reality this country could not only solve its deficit problem but restore its competitiveness with the rest of the world and embark on a growth path which will help us catch up with the EU average sooner than many presently consider possible. For this we have the thrift culture inherited from our forefathers to thank.

If we continue to delay and fool ourselves by treating the symptoms and not the root of the problem then we continue just wasting resources making an unavoidable future meeting with reality more painful and much more complicated. 

Researchers vs the People

The Malta Independent

Ten candidate countries that will accede to EU membership next year have all had such decision approved by a popular referendum vote except for Cyprus where the agreement was so broad that a referendum was considered a waste of time. There is no doubt, the people want it. Compare that to the Euro referendum in Denmark and in Sweden where the people said no thank you or at least not just yet.

Respectable economic researchers seem to think that the people got it wrong. A new study from the Cato Institute, a Washington-based public policy research foundation, challenges the belief that joining the EU will improve the competitive position of Central and Eastern European Countries (CEEC) in the world economy. It is hardly surprising that the study omits Malta and Cyprus and it is becoming quite a habit for the two island states to be taken so for granted that it is not worth anybody’s while to include in discussion or research studies.

The study, entitled EU Enlargement: Costs, Benefits, and Strategies for Central and Eastern European Countries, states that the eight CEECs will benefit from reduced barriers to trade and investment and, by 2010, free movement of labour. EU membership, however, brings with it some serious disadvantages and the Cato Institute believes that it will make the accession countries less competitive.

The study argues that the EU forces poor member countries to adopt rules and regulations inappropriate to their level of economic development. Those burdens will result in suboptimal economic growth and complying with the EU’s regulations on labour, agriculture and the environment will raise production costs, while future harmonisation of taxes looms as an additional threat to the new members’ comparative advantages.

The Cato research team recommends a two-part strategy for the new entrants:

· First, they should oppose further limits on tax competition that would make them less attractive to investors;

· Second, they should work to repeal regulations that are excessively stringent for their present level of development.

The study argues that if the new member states follow these strategies and protect their economic liberty, they can demonstrate to the rest of the EU that market-friendly reforms are good for growth. “It is to be hoped that the CEECs will be able to supply such policy competition before they themselves begin to suffer the consequences of an overbearing bureaucracy in Brussels,” concludes the study.

This is not so different from Labour’s pre-election main argument for resisting membership and supporting a loser arrangement with the EU. How is it that the people who have a direct stake in the project can be so much more positive about EU membership for candidate countries than independent academic researchers? How is it that Labour found itself more on the side of US academic researchers rather than on the side of the people?

Only time will tell whether candidate countries will make a success or otherwise of their acceding to membership. Undoubtedly membership on its own is no guarantee of success and there will be different fortunes for those who make the most of it than those who just have to live with it.

But if researchers think that CEEC’s will have difficulty to succeed when they are clearly the major beneficiaries of FDI resulting from EU membership, it will certainly be much more difficult for Malta when we have dimmer prospects of benefiting from such FDI inflows given our higher cost base and distance from the core EU market.

For us the true success of EU membership will be the discipline to force our political leaders to stop studying and analysing the weaknesses in our economic set-up and start really doing something to address them. Only then will we regain global competitiveness which will put us back on the economic map of FDI suppliers.