False promise of the European Stability Pact

Joseph E. Stiglitz, Professor of Economics and Finance, Columbia University, Project Syndicate

France, Portugal and Germany are all flagrantly flaunting the Stability Pact, the agreement among Eurozone members to keep their deficits below a critical threshold (3 percent of GDP today, but lower, supposedly, in the future). France's Prime Minister, Pierre Raffarin, defends his government's position by saying that France was not prepared to impose austerity on its own people. If France will not, other European leaders must wonder, why should they?

Monsieur Raffarin was right to say that austerity would result if France obeyed the Pact's strictures, but in debates over economic policy, the truth is seldom appreciated. Telling the truth is something best left to academics, whose squabbles make it difficult to discern who is right and who is wrong. A few years ago, Alan Blinder, then Vice Chairman of America's Federal Reserve Board, was excoriated for stating the obvious: That monetary policy should target not only inflation, but also unemployment, and that, at least in the short run, there may be a trade-off between the two.

There is a long list of central bankers' homilies that are not supposed to be questioned; do so and you are exiled from the small circle of those who supposedly know how the world "really" works. Here are three:

* An independent central bank is necessary for sound macro- economic policy. The truth: Countries that do not have an independent central bank, like India, manage to contain inflation as effectively as those with independent central banks. In Russia, an independent central banker, Viktor Gerashencko, could not be removed for years, though he tolerated both inflation and corruption. More generally, there is little evidence that countries with independent central banks grow faster, have higher wages, or generate higher incomes -- indeed, that they perform better in any real sense -- than those that do not.

* Once inflation starts, it increases at a faster and faster rate, and the costs of reversing it are high. The truth: There is no evidence of an inflation precipice, or that the costs of reversing inflation (in terms, say, of pushing unemployment to high levels) are any greater than the benefits from inflation (in terms, say, of allowing unemployment to fall to low levels).

* Inflation is bad for growth and productivity. The truth: Below a critical threshold -- a threshold far beyond the levels of inflation that now prevail in Europe and North America -- there is no evidence of significant adverse effects from inflation. On the contrary, recent research by Nobel laureate economist George Akerlof and his colleagues suggests that pushing inflation too low may impede growth, and that the critical threshold is higher for countries, such as the post-communist transition economies, engaged in large structural changes.

When an economy faces a downturn, one should engage in expansionary fiscal policies. But in a downturn tax revenues fall. Thus, debt must increase. But the EU's Stability Pact, as commonly interpreted, requires either that tax rates be raised (always difficult, especially in a recession) or that expenditures be cut. Either way, such policies will exacerbate the downturn.

The Stability Pact put into place an automatic economic destabilizer. But the EU -- indeed, every country -- should seek automatic stabilizers, policies that automatically boost the economy in a downturn. The U.S. is facing, albeit in somewhat weaker form, a similar problem.

Most of America's 50 states have constitutional amendments that effectively impose a balanced budget. As tax revenues drop due to the economic downturn, the states are cutting back on expenditures, exacerbating America's slump -- and the world's. I warned of this problem more than a year ago, and I suggested that the Federal government pick up the tab for the shortfall in state tax revenue, because the states did not cause the country's slowdown.

At the time, there was some disagreement about how long the downturn would last (I was a pessimist, and unfortunately I have been proved right). But I argued that this was irrelevant: Making up the states' shortfall would cost the government nothing if the optimists turned out to be right, but it would be just the right medicine if pessimists like me were correct. Instead, the Bush administration pushed ahead with tax cuts for the rich, tax cuts that were not designed to stimulate the economy and that, no surprise, have failed to stimulate the economy.

The lesson for Europe is clear: The EU should redefine its Stability Pact in terms of the structural or full employment deficit -- what the fiscal deficit would be if the economy were performing at full employment. To do otherwise is irresponsible.

There does need to be a commitment to fiscal responsibility. In the long run, governments should run balanced budgets, with surpluses in good years making up for deficits in bad years. But to insist on an arbitrary budgetary position in an economic downturn is to ignore everything we have learned about economics in the past seventy years, risking the well being of millions of workers who are thrown out of employment.

The Stability Pact holds another important lesson: Casting in stone institutional arrangements designed to address the problems of the past is a recipe for failure in the future. In America in the 1990's, the Clinton Administration fought demands by Republicans for a balanced budget amendment to the U.S. constitution. U.S. Democrats argued that if America faced an economic downturn, the government needed the flexibility to run a deficit. Is there any reason to believe that excessive policy inflexibility works better in Europe?