In 2012, the EU introduced a new form of its growth and stability pact. The main rules for EU fiscal policy are:

• Total Government debt must not be more than 60% of gross domestic product;
• The Government deficit must not be more than 3% of GDP except in particular circumstances.
  • (Source: EU,  Current EU rules)

Excessive Deficit Procedure EDP

If a country breaches these rules, it becomes subject to the Excessive Deficit Procedure EDP. This means that the country in question is subject to EU surveillance and must comply with EU decisions on how to deal with the high debt. The country then has to meet medium term budget requirements to reduce deficits. If countries fail to make satisfactory progress, they can be given financial penalties, (‘e.g. an interest-bearing deposit of 0.2% of GDP will be imposed on non-compliant euro-area countries’.)

Countries undergoing EDP

Currently 23 out of 27 EU countries are considered to have excessive debt and are subject to EDP.

For example, Ireland has been given until  2015 to meet the deficit requirement of 3% of GDP.   Ireland has until 2018 to meet the debt requirement of 60% of GDP. (Current EU rules)

Reasons for Fiscal Rules

1. Overcoming political resistance to spending cuts. Politicians often have an incentive to allow higher short term budget deficits and ignore the long-term consequences. Fiscal rules put pressure on governments to stick to fiscal responsibility. The EU would say the constitutional fiscal rules reduce the political cost of unpopular decisions.
2. Lower bond yields. In 2010-12, the Eurozone was hurt by rising bond yields, as markets feared the liquidity of Eurozone nations. If countries stick to fiscal rules, markets will have more confidence that borrowing will be sustainable and the Eurozone will not see the expensive rise in bond yields, which increase the cost of interest payments.
3. Single currency makes fiscal rules more important. Countries in the Eurozone cannot rely on an independent Central Bank to print money and buy bonds, therefore fiscal responsibility becomes more important. Some argue these fiscal rules are the first step towards fiscal union.

Problems with Implementing fiscal rules

• Most countries are exceeding these fiscal rules, and to comply with the rules, European governments have had to adopt strict austerity measures to try and achieve the target. This involves cutting government spending and increasing taxes. The consequence of this deflationary policy aiming at deficit reduction has been to cause lower economic growth and rising unemployment.

• Lack of alternative policies. Countries pursuing fiscal austerity, in the Euro, have not been able to adopt other macro-economic policies to stimulate demand. Eurozone countries have not been able to devalue or promote expansionary monetary policy. Therefore, there are several factors reducing demand all at once. A country like the UK, at least as its own monetary policy to offer some stimulus.

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Recently, the Economist published an article (You can fool some of the people…), pointing out several economic commentators were increasingly critical of UK economic policy and the Bank of England’s monetary policy in particular. Is the Bank of England really losing grip of monetary policy? or are they doing the best job in difficult circumstances?

Criticism of the Bank of England Monetary Policy

1. Inflation above target

The Bank of England have been given an inflation target of CPI 2% +/-1. Yet in the past five years, inflation has rarely been below the target. Inflation has frequently been higher than forecasts, and the Bank seem willing to tolerate a higher rate of inflation. In a recent article, David Smith writes:

“It (the B of E)  has rarely hit the 2% inflation target in the past eight years and, on its own forecasts will not do so in the next 2-3 years. A decade of above-target inflation is, for any central bank, flaky. The Bank has lost its compass.” (the Bank of England has lost its compass)

The Economist also worries about the persistence of missing the inflation target.

“This time, however, the Bank thinks inflation will be above target throughout the two-year forecast period. That will equate to more than five years of missed targets or, as the Bank euphemistically puts it, a temporary, albeit protracted, period of above-target inflation. (Dear Joanna, be flexible)

2. Depreciation in Sterling

Despite the threat of above target inflation, the Bank has been quite sanguine about letting the Pound depreciate. The Bank of England have given the impression that a depreciation is necessary to restore the balance of the economy – improve the current account and increase exports. But, as noted, the depreciation in the Pound has given disappointing returns. For the depreciation, we risk more inflation and a decline in living standards.

3. Quantitative easing.

As a percentage of GDP, the UK has one of the largest programs of quantitative easing in the world. However, the Bank has no clear exit strategy, and some fear that we risk a bond bubble (rising bond yields), when we reverse the policy; it could leave the UK struggling to sell sufficient gilts to finance the large budget deficits.

In Defence of the Bank of England

1. Inflation in not the major problem

The UK has experienced a longer and deeper decline in GDP than the great depression. The UK looks to be heading to a triple dip recession. This shows that the economy is experiencing an unprecedented situation of depressed demand. Given fiscal tightening, weak global growth and very weak bank lending, the Bank of England should be pursuing monetary easing. To worry about inflation being slightly above target, during this prolonged recession would be to ignore the Bank’s dual mandate of inflation and economic growth. Even if they didn’t have a dual mandate, common sense suggests the monetary authorities should  try to stimulate demand when you are experiencing a stagnating economy.

2. The inflation target is symmetrical – 1-3% not less than 2%

Some commentators have criticised the Bank for not keeping inflation below a target of 2%, but this ignores the fact the Bank of England have a target of 2% +/-1. Even by the strict criteria of inflation targeting, the Bank are targeting an inflation rate of 1-3%. It is true the ECB have an inflation target of less than 2%, but the performance of the EU economy doesn’t justify the UK suddenly adopting a stricter approach to inflation.

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A debt spiral refers to a situation where a country (or firm or individual) sees ever-increasing levels of debt. This increasing levels of debt and debt interest become unsustainable, eventually leading to debt default.

Types of Debt Spirals

• Public sector debt. This is debt that the government owe to the private sector (e.g. UK public sector debt). Some government debt may also be sold to overseas investors.
• External debt. This is debt that a country owes to other countries. It includes both government external debt and private external debt.

A debt spiral could occur with just government debt. However, if a country also has high levels of external debt, it makes a debt spiral more likely because foreign investors are more likely to withdraw funds at signs of difficulty; this is termed ‘capital flight’.

Stages in debt spiral

1. Debt Levels increase. (This could be due to overspending, inefficient tax collection, bank bailouts or economic slowdown)
2. Markets become concerned about debt levels leading to higher bond yields (higher rate of interest)
3. Higher cost of servicing debt. Rising debt increases debt interest payments. But, also Governments have to pay higher interest payments on debt because of rising bond yields. This increases government spending even more.
4. To reduce bond yields, governments need to cut spending and increase tax.
5. Trying to reduce debt can cause a recession. The Impact of spending cuts leads to lower aggregate demand more unemployment and lower economic growth. Lower economic growth leads to lower tax revenues.
6. The shrinking economy means it is harder to meet debt repayments. Confidence falls. Bond yields remain high despite the spending cuts.
7. With a shrinking tax payments, the government struggles to meet interest payments. Also markets no longer want to buy more government debt, leading to partial or total default.

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