Why is it 3%, the Deficit that is.

Baddaddy

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Oct 3, 2010
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I'm asking this because I don't know the answer, and would appreciate views.

When the setting up of the euro was announced, countries were given certain criteria that they had meet to be eligible to participate. From memory this was the late 1990's.

The most memorable criteria was that a countrys deficit could not be any more than 3% of GDP. (bundsbank influence ?)

This criteria was set when the world was a different place, prior to the wars in Iraq and Afganistan, prior to the Dot.Com bubble,prior to the global financial meltdown, to name a few.

My questions really are...

Is this 3% figure the correct figure for todays world given all that has happened.

Would another % say 5% or 7% be better for the euro conutries.

And finally, if a new % ,say 5%, was introduced what would be the effect on the euro, economic activity in Europe and Ireland.

If this sounds silly I apologise, but its bugging me.
 


setanta

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Hi Badaddy ... perfectly proper and interesting questions. I hope this helps.

The legal obligation for the budgetary rules rests on the provisions of the Treaty on the Functioning of the European Union (TFEU). Articles 121 and 126 form the legal basis for the Stability and Growth Pact (SGP) which is the key framework for managing the eurozone economy. It also commits the member states to "... avoid excessive government deficits" (Art 126.1).

In order to turn those legal requirements into policy the European Council adopts what are called Medium-Term Objectives (MTOs). The current MTOs state that fiscal deficits must not exceed 3% of GDP and government borrowing must not execeed 60% of GDP.

The global economic crisis led to the 3%/60% rules being relaxed as governments ran large budget deficits to avoid Europe tipping into a deep recession. This relaxation required governments running fiscal deficits to come back within the rules by 2014. That arrangement suits much of Europe but causes particular problems for Ireland given the depth of our economic collapse, the resolution of which is made worse by an incompetent and clueless government.

While the three main parties have committed to the MTO rules, I'm sure that the European Commission and our fellow member states in the European Council (who set this rule in the first place) will be flexible in how Ireland comes back on side. In particular, Labour is looking at how the bank bail out borrowings (some €31 billion) and associated annual interest payments (about €1.5 billion) can be treated seperately to normative government expenditure. These are likely to be the kind of responses form the European Commission to assist Ireland to meet the MTOs rather than an increase in the MTO targets.
 

Lord Wellington

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Baddaddy

It about exponential growth.

[ame="http://en.wikipedia.org/wiki/Doubling_time"]Doubling time - Wikipedia, the free encyclopedia[/ame]

If in year 1 you begin with a 7% deficit it will take 10.24 years for the deficit to equal GDP (assuming no growth in GDP).

For 3% it would take 23.45 years.

For 10% it would take 7.27 years.

Why did they choose 3%?

Bit of a guesstimate I think.

The more important question is why did the EU not stick to its own rules.

Why did they let deicits grow at a rate greater than 3%?
 

Baddaddy

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Oct 3, 2010
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548
Hi Badaddy ... perfectly proper and interesting questions. I hope this helps.

The legal obligation for the budgetary rules rests on the provisions of the Treaty on the Functioning of the European Union (TFEU). Articles 121 and 126 form the legal basis for the Stability and Growth Pact (SGP) which is the key framework for managing the eurozone economy. It also commits the member states to "... avoid excessive government deficits" (Art 126.1).

In order to turn those legal requirements into policy the European Council adopts what are called Medium-Term Objectives (MTOs). The current MTOs state that fiscal deficits must not exceed 3% of GDP and government borrowing must not execeed 60% of GDP.

The global economic crisis led to the 3%/60% rules being relaxed as governments ran large budget deficits to avoid Europe tipping into a deep recession. This relaxation required governments running fiscal deficits to come back within the rules by 2014. That arrangement suits much of Europe but causes particular problems for Ireland given the depth of our economic collapse, the resolution of which is made worse by an incompetent and clueless government.

While the three main parties have committed to the MTO rules, I'm sure that the European Commission and our fellow member states in the European Council (who set this rule in the first place) will be flexible in how Ireland comes back on side. In particular, Labour is looking at how the bank bail out borrowings (some €31 billion) and associated annual interest payments (about €1.5 billion) can be treated seperately to normative government expenditure. These are likely to be the kind of responses form the European Commission to assist Ireland to meet the MTOs rather than an increase in the MTO targets.
Thanks,

I have my doubts that the 3% target is appropriate, given the history of the last 10 years.

Any thoughts if the MTO's were changed, say 5% deficit, what effect this would have on the eurozones economy?

Would it weaken or strengthen the euro? for example.
 

weathervane

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Apr 8, 2008
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If your annual deficit exceeds nominal growth in GDP then you will become ever more indebted. So I guess this was an attempt to come up with a figure that would be below nominal growth (growth + inflation) in Europe, which was as a whole a low inflation, modest growth environment and still allow countries to run deficits during economic downturns.

It would have been preferable in my view to have a rule, as they did in the UK, of balancing the budget over the business cycle i.e. run surpluses in periods of growth and deficits in periods of recessions so that on average you are neither reducing nor increasing your stock of outstanding debt. I can see why they went for a hard limit of 3% over this though as it's a lot easier for countries to wriggle out of implementing a balanced budget over the business cycle because it depends on accurately forecasting the magnitude and duration of the business cycle.

It also provides political cover to politicians who will have to take unpopular actions to limit deficits.

If the rule were changed to 7%, then absent very high, permanent, inflation (and/or gdp growth) economies would quickly build up unsustainable debt burdens. Ultimately this would weaken the Euro because it would create the expectation in FX markets that the ECB would ultimately have to print Euro's to buy up government debt (called monetising the deficit) once it couldn't be financed by credit markets anymore. Result high inflation (possibly a hyperinflationary cycle) and declining Euro.

It does have the unwelcome side effect of limiting the capacity for running expansionary fiscal polices when they are needed though. But the EU have shown themselves to be flexible in their interpretation of it - e.g. Ireland is technically in breach at the moment but there is noone suggesting we be sanctioned.

wv
 

gijoe

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The Growth and Stability Pact says 3% because this is regarded as a level of annual deficit that a economy should be capable of managing when combined with annual growth in a mature economy i.e. if you have a 3% fiscal deficit along with 3% GDP growth then the overall national debt remains static as a percentage of the economy. Therefore, in normal circumstances a deficit of up to 3% per annum in the long-term should not add to the real debt burden on the economy.
 

smitchy2

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EU treaties.
It really should be 0% if you think about it rationally (excluding capital expenditure).
 

Outlander

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May 31, 2007
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I think its to do with money supply - running a deficit of 2% with 3% inflation means that the central bank can keep "lending" money at 2% which makes it appear that they are not printing the stuff.
 


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