Thank you. I thank the committee for inviting me here today. I will begin my remarks by noting that there has long been a debate among economists about whether macroeconomic policy is best set according to pre-specified rules, or whether it is best to let policy makers have discretion to set policy as they see fit. Personally, I am a sceptic when it comes to the desirability of legally binding macroeconomic rules. I am a professional macroeconomist and as such, I think it is important to admit to the limits of our knowledge. Governments can face policy challenges that even the most complex and clever rules may fail to anticipate. We should also acknowledge that we have a limited understanding of how the macroeconomy works. We are often one or two steps behind in understanding how things operate, and the recent global financial crisis is a very good example of that.
For these reasons, macroeconomic rules that constitute "frontier macroeconomic thinking" at one time can end up being viewed later as overly rigid and outdated. The adherence of international policy makers to the gold standard during the 1930s provides a good example of this. It is now looked upon as incredibly bad policy that deepened the Great Depression, but at the time it was considered the exemplar of monetary rectitude. However, what is noteworthy about the new EU fiscal compact - here I would echo Dr. Ahearne's thoughts - is that it already does not correspond to mainstream thinking among economists as to how an ideal fiscal policy framework should operate. Therefore, we are already starting with something that is clearly sub-optimal.
Most economists would agree that a good fiscal framework should have two key elements. First, it should guide an economy towards a moderate and sustainable level of public debt. Second, it should allow public debt to fluctuate around this moderate level in a counter-cyclical fashion, with higher-than-usual deficits in times of recession being offset by improvements in the fiscal position during expansions.
This ability to allow counter-cyclical movements in fiscal policy is particularly important in areas that do not benefit from centralised federal government transfers. Dr. Ahearne referred to the possibility of an EU federal budget, but that does not exist yet and it may never exist. It is particularly important for countries like Ireland that do not have control over their own exchange rates or interest rates. This is the crucial macroeconomic tool that we have and it is really important that we can use it in future in a counter-cyclical fashion, as opposed to the way we have traditionally used it, which is pro-cyclical.
In terms of those two elements, moderate debt levels and counter-cyclical fiscal policy, the fiscal compact echoes the already-existing "six-pack" in emphasising the need to get the debt trajectory down towards 60% of GDP. I think that is a good thing. It is not new in the fiscal compact as it already exists in the "six pack", but we could argue for putting a formal trajectory for getting the debt towards 60% of GDP on an EU treaty footing.
However, the key innovation in the compact is the so-called golden rule, setting a maximum structural deficit of 0.5% of GDP when a country has a debt ratio above 60% and a maximum of 1% when a country has a debt ratio lower than 60%. In addition, independent of the cyclical adjustments that are factored into structural deficits, the maximum overall deficit is supposed not to be higher than 3% of GDP.
Much of the press coverage on this issue makes it seem as though a balanced budget over the cycle is just innately desirable, and the people who designed this think that this corresponds to the homespun wisdom of the famous Swabian housewife. However, an aggregate economy is not a single household and these comforting comparisons can be highly misleading. In my opinion, the golden rule is in fact a very poor rule that does not correspond to either of the two principles of good fiscal policy that I have outlined.
The rule on moderate debt levels, if followed over time, will lead to debt ratios that are far below what anybody would consider moderate. We can say that most European countries have very high debt ratios now, so why are we worried about having low debt ratios in future? These are fixed and irrevocable rules. We are supposed to obey these rules for many years. We need to think ahead. An economy's debt-to-GDP ratio tends to converge over time towards the ratio of the average deficit to the average growth rate of nominal GDP. What does that mean in this case? Let us suppose that the nominal GDP of a country grew at 4% and consists of 2% real growth and 2% inflation - that is a pretty moderate level of growth - then an average deficit of 1% of GDP, when debt is below the 60% figure, will not stabilise the debt at 60%. It sends the country's economy steadily towards 25%, which is the ratio of the 1% deficit to the 4% growth rate.
If these rules are adopted, they will see all European countries on a steadily declining debt down to the point of a maximum of 25%, but in practice it is a call for the elimination of sovereign debt markets. Of course, people think debt is a bad thing, but one person's debt is another person's asset. Government bonds are used by pension funds and banks all around the world, and people need to think in a joined-up way about this proposal to effectively abolish sovereign debt in the long run. The rules will also severely limit the ability to use fiscal policies for stabilisation purposes in a manner consistent with long-run stable debt levels. For instance, if a 60% debt-to-GDP ratio is considered acceptable with a 4% nominal GDP growth rate, a country could have an average deficit of 2.4% per year and still stabilise the debt at 60%. That would allow the country to have cyclical fluctuations in which the deficit goes two or three percentage points above or below that; thus, it could have deficits ranging from 0% or a small surplus to 5% and still stabilise the debt at 60%. That would be a perfectly sensible counter-cyclical fiscal policy. A country could not run that under this system, because it would hit the 3% debt limit with the smallest downturn in the economy.
The legal invocation of the idea of a structural deficit is unfortunate. This is a purely theoretical concept; empirical measures of it can differ widely depending on how the analysis is done, and can often be subject to big historical revisions. The European Commission now says that Ireland was running large structural deficits prior to the crisis, but that is not what it said before the crisis happened.
I have no doubt that the political realities of a post-EFSF European Union require a greater commitment to fiscal responsibility, but Europe could have achieved this with a far better set of rules than were arrived at in this rather hastily put-together treaty. At least those who inflicted damage on the world economy by sticking to the gold standard in the 1930s can claim to have been following prevailing economic thinking. I do not think the politicians who have designed these rules will be able to invoke that defence in the future.
All that said, although I think the economics of this treaty are pretty terrible, on balance, the arguments favour Ireland's signing up to it. There are two reasons for that. As Dr. Ahearne noted, our current debt ratio is so high that we are set for a long period of tight fiscal policy with limited or no room for the use of counter-cyclical fiscal policy. Thus, in the medium term, we will have to do what we have to do anyway. Second, if indeed it is the case, as the preamble to the compact asserts, that the treaty needs to be passed to allow a country access to ESM funds, this is a powerful argument, on its own, for signing the treaty. Even those who believe we are on course to return to the sovereign bond market before the end of the EU-IMF programme must acknowledge that the possibility of the ESM safety net is there, and this is an important factor in investors' minds. If we remove that safety net, the chances of our being able to walk away from the EU-IMF programme on our own and return to the sovereign bond markets are extremely low.
Economic policy-making rarely amounts to picking the best possible policy suggested by economic theory. In a choice between an overly restrictive and badly designed fiscal compact and the potential alternative of being denied funding for our fiscal deficit next year - and the more extreme possibilities of sovereign default or exit from the euro - we should stick with the European project and hope, however difficult this may be, that we can work to improve its design in the future.