‘Treaty would not have prevented crisis’

A damning report on the fiscal treaty and its new rules intended to have eurozone countries run close to balanced budgets has been released by Davy Stockbrokers.

Davy chief economist Conall MacCoille believes that if the treaty had been in place over the past decade, it would not have identified or prevented Ireland’s economic crisis.

Some elements of the rules are vaguely defined while some of the guiding targets are little more than vague, theoretical concepts that will be difficult to measure.

Instead, he says, Ireland should push for IMF recommendations on mutual insurance mechanisms that could have preserved the country’s creditworthiness if they were in place.

The Government should also pursue the IMF recommendations for the country “not least because they highlight that the sovereign has borne too high a cost in recapitalising banks and deserves additional support from Europe.”

It adds that Ireland has little choice but to ratify the treaty, and notes that potential access to funding support from the ESM is conditional on ratification.

The new fiscal compact has two key rules: the structural budget deficit must equal 0.5% of nominal GDP; and when debt exceeds 60% of GDP, additional fiscal measures must be taken to reduce it by one-twentieth of the difference.

This debt ratio does not allow fiscal policy to stabilise the economy although it does allow for an exception — the country’s recession would have qualified for instance and so would not have led to a sharper fiscal consolidation had it been in place, the report says.

The 0.5% structural budget target is exceptionally poor and is unobservable as the estimates are prone to revision and subject to dispute long after the event, the report says.

For example, the IMF has revised its judgment that Ireland ran a structural budget surplus in various years to saying it ran deficits. In contrast, the European Commission still estimates the country was running structural surpluses.

The report asks how the European Court of Justice will be able to make a ruling based on the structural balance criteria if it is asked to impose a fine of up to 0.1% of GDP for non-compliance with the treaty, as the fiscal compact allows for.

This contrasts with the CPI inflation targets adopted by central banks in recent years that can be independently observed. “The fiscal compact clearly lacks that transparency. It is as if a darts match has been arranged in which neither the players, the audience nor the referee can see the board”, the report says.

Rules do not necessarily form the best basis for policy as illustrated by the property bust when financial regulators believed Irish banks were well capitalised because they adhered to the Basle II capital requirements, rather than looking at the actual risks on their balance sheet.

Ireland may have benefited from mutual insurance mechanisms to guard against the threat to the public finances from the banking system and to limit the extent the banks were able to inflate the property boom.

The IMF made some recommendations in this regard last October, including proposals for common European funds to insure bank retail deposits and recapitalise failing banks, together with macro-prudential instruments to stop banks from inflating regional asset price booms within the euro area.

“The natural conclusion of the IMF’s proposals is that the Irish Government has borne too heavy a burden in recapitalising banks. Hence, pushing the IMF’s proposals may encourage EU institutions to provide additional support in bearing those costs, as advocated in the IMF’s December 2011 review of the funding programme”, the report says.