Will Europe’s Fiscal Compact Work?

CAMBRIDGE – At the start of 2013, the eurozone’s “fiscal compact” entered into force, owing to its ratification on December 21 by a 12th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement. The compact – technically called the Treaty on Stability, Coordination, and Governance in the Economic and Monetary Union – requires member countries to introduce laws limiting their structural government budget deficits to less than 0.5 % of GDP (or less than 1% of GDP if their debt/GDP ratio is “significantly below 60%”). So, will this new approach work?

A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent – and only to the extent – that the gap between revenue and spending is cyclical (that is, its economy is operating below potential due to temporary negative shocks). In other words, the target is cyclically adjusted. The budget-balance rule must be adopted in each country – preferably enshrined in their national constitutions – by the end of 2013.