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Can the Euro's Fiscal Compact Cut Deficit Bias?

Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 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 ½ % of GDP. 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 is cyclical, i.e., that 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 in their national constitutions, by the end of 2013.

Will the new approach help? The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.

There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year. ["The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time."] But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction. Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere. During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely. Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies. During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound. Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.