Monthly Archives: January 2017

What is “long-term debt sustainability” or “kestävyysvaje” all about?

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What’s at stake?

In Finland, when the media and various special interest groups debate about the current economic and fiscal policy stance of the government, one cannot avoid the term sustainability deficit or “kestävyysvaje”. In economic policy circles it is also known as the S2-indicator. Given the heated political discussion on fiscal stance, I thought it might be a good idea to try to explain it in ‘layman’s terms’ what the indicator is all about. So dear media and politicians, let’s have a go.

The idea of fiscal policy sustainability is mostly defined around the following abstraction: we say that a policy stance is sustainable if the present value (sum of discounted cash flows) of future primary balances (budgetary surplus/deficit without interest expenses) is equal to the current level of debt.  So sustainability is an intertemporal budgetary constraint for the government. Then we can define S2 or “kestävyysvaje” in the following way: S2 is the immediate and permanent one off fiscal adjustment that would ensure that the intertemporal constraint is met.

Debt dynamics (accounting identity)

By definition, we can express the change in annual debt by

D_{t+1}=(1+r)D_t-PB_{t+1}

The equation tells us that the annual change in government debt is the sum of : interest expenses on the current debt stock and the negative primary balance. This is an accounting identity and true by definition.

..and S2 derived from it

After some lengthy calculations, assuming that the interest rate is constant, we get the following expression for the S2-indicator

S2=rD_0-PB_0 +r\sum_{i=1}^{\infty}\frac{\Delta A_i}{(1+r)^i}

where the third term represents the ageing related costs according to the decomposition

\Delta PB_i=PB_i-PB_0=S2-\Delta A_i

The previous equations tell us that the “kestävyysvaje” is sum of three terms : 1) the interest rate times the current debt 2) primary deficit 3) present value of age related costs times the interest rate.

This all tells us that that S2 depends crucially on the initial debt and initial deficit and projected age related costs. Of course the expected rate of interest matters a great deal as well.

Where are we now?

European Commission currently sees that the “kestävyysvaje” for Finland is some 3,2 % of GDP at market prices, so some 6-7 billion euros. This would mean drastic budgetary cuts, if implemented one off. However, currently it is perceived that at least to some extent structural reforms can bring down the figure a bit.

Structural reforms lower the present value of ageing costs

As can be seen from the formulas above, to bring down the kestävyysvaje, one could implement structural reforms in order to bring down the present value of ageing costs

Critique

In my mind, the S2 is an indicator on where we stand, it should not be a strict and rigid policy rule that should be followed religiously. Given that there is more or less a  consensus on the figures across research institutions , and  COM, BoF, MoF, we should see it as a strong indicator that the current level of spending and debt is unsustainable with respect to the projected ageing related costs. Of course there  is a lot of uncertainty and sensitivity analysis is important.

What about net debt and the definition of general government figures?

Put aside the previous figurative considerations, I think we should be more worried of the fact that “TyEL” is included in the general government deficit figures. In practice I find it difficult to imagine that the government would confiscate the private pension system assets and liabilities. So if there is too much pessimism and uncertainty in the determination of kestävyysvaje, I think there is too much optimism that the pension system would provide budgetary revenues to the annual government budget.

On net versus gross debt: one should also consider whether the government could shrink its balance sheet by selling financial assets. This would bring down the kestävyysvaje, as S2 is determined on a gross debt basis. One could bring down the debt from current 102 bn to some 75 billion or so by considering selling the liquid financial assets. On the other hand, leveraged government investment activity might be rational, iff the risk adjusted returns on financial assets are at least large enough to cover the interest expenses on government debt. This is risky business however, and its therefore difficult to say what is the optimal anount of leverage.

Why all the fuss?

“According to the system of national liberty, the sovereign
has only three things to attend to… first, the duty of
protecting the society from the violence and invasion of
other independent societies… secondly, the duty of
protecting … every member of the society from the
injustice or oppression of every other member… and
thirdly, the duty of erecting and maintaining certain public
works and certain public institutions, which it can never be
in the interest of any individual to erect and maintain”
-Adam Smith 1776

An Inquiry into the Intellectual Origins of the Monetary Union and the Way Forward

 

 

As it is almost the 60th anniversary of the Treaty of Rome, I find it important to share some thoughts on the intellectual history of the monetary union in Europe. Given the plethora of various opinions on the current state of affairs, I will rather focus on the historical essence of the EMU. The focal point of this short essay is the substantial work around the Delor’s Committee. As it will be evident, most of the issues debated today are not unlike those discussed in the Committee. Finally, I will present some thoughts on the way forward.

 

I will not contemplate excessively on the reasons and rationale behind the monetary union, for those interested, should consult academic journals on the integration process. I will just mention two factors, first, namely the price that Germany had to pay for its reunification and the countermeasures to restore the balance of power within Europe and second, the proactive role of the Commission. One should not underestimate the role of “randomness and nonlinearity” either, especially when it comes to the currency market turmoil and the political repercussions in the 1980’s.

 

From the ashes of WWII

 

If there is some logical sequence of events at all, I think one of the most reasonable starting points would be that of the Second World War. By the 1944 it was already evident that the Allies would be victorious and thus a group of wise men commenced their deliberations and negotiations on the international monetary order. The result was the Bretton-Woods system. It was basically a system of fixed exchange rates, where the dollar acted as a focal currency; the dollar was tied to a gold standard, while other major currencies were tied to the dollar. The newly established IMF acted as a fiscal coordinator and a lender of a last resort. At this time, it was generally agreed that the role for the Bank for International Settlements (BIS) was to deal mostly with European issues. Finally, as we all know, the European Economic Community was established in 1957. EEC became reality some 7 years after European Payments Union was established in 1950 to facilitate settlements among some European countries. The Treaty of Rome included a provision to establish the Monetary Committee of the EEC, a predecessor of the Economic and Financial Committee (EFC). I used to work in the EFC Secretariat in 2012-2015.

 

Then entered the ‘Big Society’ of Lyndon B. Johnson and the Vietnam War. This meant excessive fiscal spending and ultimately Richard Nixon effectively defaulted by detaching the dollar from the gold standard in 1971.

 

Werner Report

 

However, already in the 1960’s international finance was in the state of disruption and hence the EEC (European Economic Community, the predecessor of the EU) Council established the so-called ‘Committee of Governors’, CoG, that composed of Member States’ central bankers.  BIS provided the logistics and a secretariat for the CoG. This is the predecessor of the ECB Governing Council.

 

Then, in 1969 the Heads of the State or Government of the EEC, based on a proposal of the EEC Commission, agreed to mandate the Werner Committee to draft a plan for establishing a monetary union. The plan was to have it up and running by 1980. It failed. However, what is particularly interesting is that it basically contained most of the elements people are discussing today. For example, the report recommends transferring extensive powers at the Community level, as well as it recommends establishing a “European Fund for Monetary Cooperation”. Economic policy coordination, structural reforms and common fiscal rules are all there. Extensive fiscal transfers are there as well.

 

As regards to the European Fund for Monetary Cooperation, the report states:

 

” This fund will have to absorb the mechanisms for monetary support at short term and for financial aid at medium term. As progress is achieved towards economic and monetary union, the fund will gradually become an organ of management of the reserves at the Community level and be integrated at the final stage in the Community system of central banks which will then be set up.”

 

The EFMC was the grandfather of the ECB/ESM. The fund was actually set up via a Council regulation in 1973. BIS provided the technical support needed.

 

Snake, EMS, Single European Act

 

In spite of the ultimate failure of the Werner Plan, the report was adopted in the sense that some of the recommendations actually realized, like the EFMC. Among with it, the “snake in the tunnel” was established in 1972, which aimed to a limited variation of exchange rates between Member States. Ultimately the US default in 1971, global stagflation and other depressing developments in the 1970’s killed the snake as well.  What followed was the European Monetary System (EMS) in 1979. EMS established the ECU currency, a basket currency of EMS Members and brand new bandwidths for Member currencies (ERM). Finally, the agreement on Single European Act in 1986 marked a milestone in the politics and economics of the single market and monetary integration.

 

Enter Jacques Delors

 

The monetary policy stance of Paul Volcker caused many problems in the early 1980’s. After the Plaza Accord in 1985, the situation got worse inside the EMS. The ERM was strained, excessive balance of payments distortions and currency variations were common. Finally in 1987, the French finance minister Edouard Balladur asked the Monetary Committee and the CoG to think about how to improve and strengthen the EMS. It was only in the summer of 1988, when the HoSG mandated Jacques Delors, the President of the EEC Commission, to chair a committee that would draft the way forward. This resembles the contemporary process of completing the EMU –workstream by the 5 presidents.

 

The Delor’s Committee was, in my mind, the intellectual nerve-center of the proto-euro. Established in 1988, the committee was chaired by the Commission president Jacques Delors. Other influential figures were Jacques de Larosiere, Wim Duisemberg, Alexandre Lamfalussy and Karl Otto Pöhl among others. The rapporteurs were provided by BIS, and apparently at least Tommaso Padoa-Schioppa had a very prominent role there. Hans Tietmeyer was the president of the Monetary Committee at the time. To me it seems that Padoa-Schioppa was the prominent intellectual in the group and it seems indeed that he provided most of the input within the committee.

 

By the way: there is an interesting quote from Karl Pöhl from 1988:

 

“In a monetary union with irreversibly fixed exchange rates the weak would become ever weaker and the strong ever stronger. We would thus experience great tensions in the real economy of Europe…In order to create a European currency, the governments and parliaments of Europe would have to be prepared to transfer sovereign rights to a supranational institution.”

Karl Otto Pöhl was the president of the Bundesbank from 1980 to 1991. He was also the president of the monetary committee in 1976-77. One of the founding fathers of the euro as well.

 

The report itself was signed in May 1989. I present here some of the key considerations:

First of all, the report identified most of the issues that were in Werner report. Greater convergence of economic performance was utterly needed. More intensive and effective policy coordination was suggested as well. Transfer of powers from sovereign states to the Community in monetary and macroeconomic management was deemed necessary. Strict budgetary rules. Complete liberalization of capital transactions, full integration of banking and financial markets was needed as well.

 

The following excerpt shows clearly, that the risks were identified broadly as well:

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It seems though that the imbalances were meant to be dealt with policy corrections and only to a limited extent in terms of fiscal transfers. There was some support for a European Reserve Fund as well, which would act as a some sort of lender of last resort. My impression is that Padoa-Schioppa at least realized that a system of fiscal transfers is needed, in order to keep the system stable. These recommendations were not in the final report, for political reasons I guess.

 

The secretariat of the committee however envisaged a system that was framed “European Fiscal System”. My understanding is that this system would be the proto-Treasury of the Euro area. It did not fly. But this just illustrates how the problems were acknowledged and how political reality works.

 

The rest of the story goes through Maastricht and ultimately to the present day. I will not discuss those developments here. In the very end I will touch upon these issues a bit.

 

Delors’ report in 2017, where are we now?

 

In the light of recent developments, I would say that we still seem to face more or less exactly the same challenges that were identified already in the late 1960’s. Werner report and Delor’s report both are centered on a couple of focal points: first of all, for the monetary union to work, we would need more integration in terms of economic performance. We would also need more flexibility, when it comes to wage and price setting and the mobility of labor. Given the impression that the founding fathers of the Euro had, this would be necessary but alas however not sufficient.

 

We would also need a substantial transfer of sovereignty from the Member States to the Community level. Even this would not suffice. We would need also a permanent fiscal transfer mechanism from the wealthy to the less wealthy Member States. This was at least the perception of Mr. Pöhl and Mr. Padoa-Schioppa. If we take these assumptions of technical necessities as given, we can compare what we have actually achieved.

 

First of all, we have achieved a lot. We have more stringent macro-fiscal-policy co-ordination, we have the two-pack, the six-pack and the Fiscal Compact. The rules are there, and in theory we can intervene at the Community level, if a Member State has excessive deficits in its budget and/or current account/balance of payments. The political logic of enforcement is a different story. We have the European Semester that includes Country Specific Recommendations (CSRs). Enforcement? Again a challenge.

 

What about flexible economies. Not so much. In Finland the recent political history suggests that structural reforms are politically extremely difficult to implement. And Finland is a pragmatic country. Wages and prices are inflexible in practice.

 

In terms of financial integration, things look better. The recently (almost) completed Banking Union introduced a common rule book, common supervision, and common resolution and on top of that, the discussions around common deposit insurance are on-going. Again, implementation and enforcement seems to be the problem, not the rules themselves.

 

On a permanent fiscal transfer mechanism, the recommendations of the founding fathers are not in place. A fiscal transfer system would mean basically that we would need to establish a Community –wide taxation –system , which would fund Community transfers, just like within a Member State. The taxing system would in the spirit of “no taxation without representation” demand also an ultimate power for the European parliament to decide on the taxation and on the extended budget for the Community, and this seems far-fetched, at least for now. And if one is to have a federal budget, one would need federal (euro)bonds as well. Given that the evidence of a true European spirit and identity are missing, to say the least, this might prove to be the biggest hurdle on the way to full integration. Of course it is possible that these steps will never be taken. At this time, these kinds of policies would backfire quickly and would most likely demand a strong qualified majority in national parliaments. Without a European identity, hard to see happening any time soon.

 

Although not meant to be permanent transfer mechanisms, we have some ripples of the idea of a Euro area treasury. We have the European Stability Mechanism. It is more like a treasury and less like a European Monetary Fund as it funds itself from the capital markets instead of the central banks. And it is not really a European entity, as it is not part of the primary legislation. In the press, I have seen at least FinMin Schauble of Germany and some ECB executives promoting a more prominent role for the ESM.

 

Conclusions

 

All and all, when one looks backs to the history of the EMU, one sees actually a one rather coherent and fluid story. The fixed-exchange system of the Bretton-Woods in my view caused the balance of payments problems, which lead to the idea of Euro area (a fixed-rate system in a way). I have no doubts that the more idealistic types had dreamt of a single currency since the inception of the EEC. We are part of this magnificent process of economic and political history in the making. The integration process has advanced slowly but nevertheless consistently.

 

Even though the Euro area is far more resilient than before, the critical building blocks of a true monetary union are missing still. There are those who believe that the Euro is viable as it is, more or less. I don’t share this view. From purely a technical point of view, I think a viable monetary union needs two things still:

 

First it needs to obey its rules it imposes on itself; and second, it needs a fiscal stabilization function, i.e. permanent fiscal transfers in the form of a federal taxation. And taxation needs a federal institutionalization of the Community. The latter is more difficult to implement and it is up to the European peoples to make up their minds and decide on the matter. The current state of affairs is not sustainable.

 

I can hardly see a convergence process where one-size-fits all monetary policy would actually work. This would be of course the ideal state of affairs. But the fact is that the flexible convergence in terms of economic performance is still wishful dreaming. One price of money=interest across the Euro area means too low interest rates for some, and too low risk premia for others. What usually then follows is a huge problem in the banking sector, and ultimately a credit crunch with all its ugly side effects. That is why the responsible thing to do is to decide which road to take, and decide rather sooner than later.