In this column we argue in favour of a classic “golden rule” rather than the one proposed by the fiscal compact. By focusing on European “green” public investment financed via the issuance of euro bonds Euroland could spur green growth and – at the same time – make an important step towards a workable fiscal union.
Green growth features high on the international policy agenda prior to the Rio+ meetings scheduled to take place in mid-2012. At the same time the euro area is stagnating as a whole and shrinking country by country with fewer and fewer exceptions. In the advent of the French election European leaders are finally at least mentioning the necessity of growth impulses other than “expansionary austerity” hopes. However, they remain nebulous about what they mean and their current crisis strategy still centres on the “fiscal compact” agreed upon by the heads of State or government of 25 EU member countries in January 2012. Growing out of a debt crisis by austerity policy has historically never worked. The fiscal compact will not deliver on economic growth, let alone on green growth. A different golden rule is needed for stimulating green growth in Euroland.
A golden rule that is not golden
The so-called “golden rule” proposed by the fiscal compact is not a golden rule at all. Karl Whelan has recently shown that following the rules of that compact, i.e. a maximum structural public-deficit-to-GDP ratio of 1% (for those countries whose initial public-debt-to-GDP ratios lie below 60%), on the quite realistic assumption of nominal GDP growth of about 4% p.a., will result into a public-debt-to-GDP ratio of 25%, which according to Whelan is “far below what is required to operate a sensible and stabilising fiscal policy”. Stijn Verheistadded that this “golden rule” would effectively be stricter than any fiscal rule adopted by the EU before the fiscal compact, considering both nominal growth perspectives and initial debt levels across the Union. He has thus raised doubts about the soundness of its design. In particular, the “golden rule” in the fiscal compact neglects the important distinction of public consumption and public investment.
The true golden rule
Reviving the well-known golden rule of public finance (eg Dafflon 2010) could help to promote not only growth, but also greening this growth both in the euro area and in the EU as a whole. For very good reasons, for economists the golden rule of public finance means that only public investments should be financed through public indebtedness. The fiscal compact needs to be clarified and re-adjusted on this crucial point. In fact, as any investment expenditure provides a number of public goods or services for several fiscal generations of taxpayers, it would be wrong on both ethical and economic grounds to ask the current generation of taxpayers to finance this expenditure entirely.
Public investment can and should be financed by public debt, to be served according to the pay-as-you-use principle, which implies that each generation of taxpayers has to contribute through their own taxation to financing amortization and interest payment of the relevant public debt. Provided that this debt service (i.e. amortization and interest payment) is included in the current account of the public sector, which has to be balanced yearly, the relevant investment expenditure should be booked in a separate capital account, which should be financed by the issuance of sovereign bonds.
It is well documented that public investment has a positive effect on economic growth, particularly as there are crowding-in (rather than crowding-out) effects. For example, in the case of transportation and communication investments, government spending often stimulates private investment, which can spur a productivity push during the building-up of the relevant infrastructure. Likewise, public investments in education and in the health sector also contribute to economic growth. This elaborates on the need pointed out by Collier to disaggregate public investments into social and economic projects, and further to examine whether or not the relevant investment will generate taxable income during its life span. It also substantiates the argument raised by a recent IMF Working Paper that “public investment projects included in fiscal stimulus packages for 2009–10 should increase growth, even with lags in their implementation, provided public capital levels are not too high to begin with and the resulting financing costs and high tax rates do not negate the positive benefits of new public investments.”
Greening growth in the euro area by means of European public investments
Greening European growth requires more than just internalizing external effects. Often there is a need of complementary investments. Further, inertia in both R&D activities and agents’ behaviour has to be overcome. For instance, the recent boom in the photovoltaic industry must be accompanied by smarter electricity grids with intelligent storage possibilities across national borders. Public investment in pan-European infrastructure, such as smart power grids, road and railway infrastructure, and telecommunication networks is therefore key to greener growth in Euroland. Such projects are genuinely European, as they are often cross-border and benefit many or even all member countries. Financing such projects would be seriously constrained by the “golden rule” of the fiscal compact. Moreover, classical prisoner’s dilemmas between the concerned euro-area countries are likely to occur, despite the fact that such projects do offer a high return for future generations and can currently be financed at very low costs. Debt finance of such public investment at the European level would be an important element of both intra-Euroland and inter-generational fairness. Thus, what is needed is a balanced approach of combining relevant debt brakes on national government consumption and a pan-European investment programme for kick-starting green growth.
Renewing economic policy management across Euroland
Carrying out Euroland’s public investment for sustainable growth in a well-designed way can bring three additional innovations in economic policy management with it.
On the financing side, these investments could be financed by new euro-bonds as AAA assets. Their potential role as secure investment opportunities for institutional investors like pension funds is plain, as well as their potential use as an important instrument for the conduct of the ECB’s monetary policy (notably as a long-run replacement of national debt as collateral). Moreover, this would be a start for a common fiscal policy based on joint growth-enhancing projects across euro-area countries.
On the fiscal policy side, this would create a first step towards an effective fiscal union, with the possibility to conduct a truly European fiscal policy.
On the institutional side, such pan-European investment projects should be planned, executed, and supervised expertly and independently, for example by institutions like the European Investment Bank and/or the European Bank for Reconstruction and Development as already earlier suggested by a group of economists to the President of European Council.
In sum, the real issue now is that European policy makers should avoid repeating the mistake they did with the introduction of the Stability and Growth Pact: devising numbers that were not founded in any economic theory or actual experience, thereby turning out to be ignored in practice and completely losing credibility. Returning to some good old ideas like the economists’ golden rule, and combining it with credible institutions supervising its application, could do a lot for returning to GDP growth and turning it to a green and sustainable growth path for the whole euro area.