Fiscal Tickery

Thanks David for the link. I haven’t commented on this because like Dutch finance minister Zalm (who I imagine working away weblogging into the early hours under a dim light provided only by his mobile phone) I am tired. I can’t help feeling that everything that needs to be said has already been said, and many times over. Now all we can reasonably do is wait and see the consequences.

From where I’m sitting they may in fact not be too long in coming. Now this, as I’ve said many times over is not an economics blog, but sometimes it’s impossible not to get entangled a bit. Looking at the Economist article David points to, I cannot help noticing this:

Member governments have found it impossible to live with the pact. But can they live without it? So far, the financial markets seem to think so: for them, ignoring the pact was a less troubling outcome than enforcing it. Now they can look forward to a cyclical recovery in Europe unthreatened by inopportune fiscal rigour. The return of growth should restore most euro-area governments—in France, Germany and elsewhere—to a better fiscal balance. As it does, the hoo-ha over excessive deficits will recede.

I really cannot agree with this interpretation of the market reaction. I don’t think there was a huge welcome for the decision, I just think there is no alternative to a relatively high euro at the moment, since the consensus view is that the dollar is overvalued. So the euro is staying up by default. This is not a very happy situation, and I would consider it a highly unstable one. If you want we are in an unstable, not a stable equilibrium: we are resting stationary on the hilltop, not sitting comfortable in the valley bottom.

I also think that the ’return to growth’ scenario, particularly in the German case, is like spitting in the wind. The pact and the ’structural reforms’ went hand in hand. Now the idea is that despite suspending the pact the reforms will go ahead. But, as I have argued long and often, these reforms - necessary as they may be in many cases - are growth and consumption negative, not vice versa. Germany has little way out of a protracted period of more or less painful adjustment. I wouldn’t be expecting any ’growth miracles’. Now the big danger is that the pact is gone and that one and two years from now the deficit remains the same or worse, without any serious growth impact. This is when the real effect of what just happened would be noticed, and this is where comparisons with Bush’s now famed fiscal trainwreck would spring immediately to mind.

Why is this? Well again, I think I’ve been arguing it long and often, and like I said, like Zalm, I’m tired. Even I am begining to get bored with me. I prefer to wait until the writing on the wall gets just a little bit clearer, and there is really something new to say. So for a change, why don’t I hand you over to Bloomberg’s Caroline Baum. It may be a bit of a rant, but the points she is making are valid. And if we’re knocking Bush, and not saying the same over here, then we really aren’t being either very coherent or very consistent.

Party On, Euro. The Fiscal Time Bomb Is Ticking:

Caroline Baum

Nov. 28 (Bloomberg) -- Germany and France, the euro zone’s two largest economies, dodged another bullet.

The two countries, the linchpin of the European monetary union, were given more time to reduce their budget deficits to comply with the Growth and Stability Pact, one of the cornerstones of monetary union.

Tuesday’s contentious meeting of European finance ministers ended with a hardly unanimous decision to give Germany and France until 2005 to bring their deficits down to 3 percent of gross domestic product, a target they’re expected to exceed for the third consecutive year in 2004. The Organization for Economic Cooperation and Development already cast doubt on the viability of the 2005 deadline.

The smaller countries weren’t happy: Ministers from Spain, Finland, Austria and the Netherlands voted against giving Germany and France a stay of execution. The European Central Bank was miffed. The European Commission was outraged. Economists wrote the epitaph of Europe’s fiscal-policy framework.

And as for the euro, it suffered a mild case of dyspepsia lasting 24 hours before it went back to basking in the glow of the dollar’s despised status. After all, the U.S. is the one with the really bad fiscal problem.

Tick, Tick, Tick

Not so fast. “A pension time bomb is threatening European integration,” says Jose Pinera, the founder and president of the International Center for Pension Reform and the architect of Chile’s pension privatization.

Europe’s aging population, high structural unemployment, huge unfunded pension liabilities and generous welfare state -- not to mention constituencies that go on strike at the mere suggestion of any diminution of benefits -- make its pending fiscal crisis worse than that of the U.S., according to economists who use governments’ future liabilities to calculate the fiscal gap.

And because Europe’s union is monetary, not political, its future is threatened.

“History suggests that asymmetric fiscal problems quickly cause monetary unions between fiscally independent states to dissolve,” Pinera says.

Pinera, a pied piper of pension reform, divides Europe into two categories, which I’ll call “good” and “bad.” In the good group are countries with large private pension systems (the U.K. and the Netherlands), countries that have recently introduced personal retirement accounts (Sweden and Poland), and countries with sound public finances (Ireland and Luxembourg).

Bad Lands

In the bad (and ugly) category are the big monetary union countries: Germany, France, Italy and Spain. These countries “have no private pension systems and are hugely in debt,” Pinera says. “Their fiscal problems pose an enormous problem to the unity of the euro zone.”

Tweaking the current pay-as-you-go system -- modest tax increases here, small benefit reductions there -- won’t work. Only structural reform will solve Europe’s looming pension crisis.

“If Europeans don’t want to have babies, they have to have money in private pension accounts,” Pinera says.

The good countries, which joined the European monetary union so they could be more like the bad countries when they were good, are learning that those who made the rules don’t have to play by them. With their own finances in relatively good order, these countries won’t want to bear the costs of compliance forever. Nor will they want to see the value of the euro eroded by inflation, the old-fashioned way for governments to meet outstanding obligations.

Generations Apart

The U.S. faces a crisis as well, with the baby boomers getting ready to retire and the two largest social insurance programs, Social Security and Medicare, threatening to gobble up the entire federal budget.

Traditional budget accounting, which concerns itself with the annual or multiyear deficit/surplus and total national debt outstanding, may have been fine when the government was spending money on planes and roads. With huge demands from these unfunded programs, some economists are advocating generational accounting as a better measure of a country’s fiscal gap.

Generational accounting calculates the present value of all current and future government obligations -- spending on goods and services, transfer payments and net debt -- and offsets them with current and expected tax receipts in an attempt to measure the “fiscal burdens confronting current and future generations under existing policy,” says Laurence Kotlikoff, professor of economics at Boston University.

‘Menu of Pain’

The news isn’t pretty. According to an analysis economists Jagadeesh Gokhale and Kent Smetters did for the Treasury that was buried and subsequently published by the American Enterprise Institute, the U.S. fiscal gap is about $45 trillion -- and that’s before the new Medicare prescription drug benefit is factored in.

What would it take to eliminate the fiscal imbalance? Gokhale and Smetters’s “menu of pain” outlines various options:

-- double the current payroll tax of 15.3 percent, with no cap;

-- increase federal income taxes by two-thirds;

-- cut Social Security and Medicare benefits by 45 percent;

-- eliminate all federal discretionary spending.

The viability of all of these options suggests some degree of pension privatization is the only way out of demographic distress, as fewer workers support a growing number of retirees.

Deaf Ears

If the dollar’s current weakness is about the lack of budget discipline, what should we say about Europe’s predicament?

“By 2025, nearly one third of Europe’s population will qualify for retirement benefits,” Pinera says.

Drastic payroll tax increases or benefit cuts would be required just to keep the pension system going. Ultimately the constraints would lead to a “generational war, with young people resenting higher payroll taxes and the confiscation of their savings,” Pinera says.

Both Kotlikoff and Gokhale agree that Europe faces a bigger pension hurdle than the U.S., with Japan holding the No. 1 ranking.

Kotlikoff, who’s been preaching fiscal Armageddon for 10 years, is “short bonds,” has a “big mortgage” (counting on inflation) and is “thinking about gold.” He’s still waiting for capital markets to catch on.

“Our country is bankrupt,” he says.

I ask him when everyone else will get the joke.

“As soon as bond traders who read Bloomberg News read this and understand, they will mark bonds way down in price,” Kotlikoff says.

I gently remind him I spoke to him and wrote a column on generational accounting three years ago. Everyone must have missed it.