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Fixing Europe's Stability Pact

Europe's Stability Pact - which underpins the euro by setting fixed constraints on the size of budget deficits for euro members - is in trouble. The European Union's leading country, Germany, failed to meet its commitments to its EU partners concerning its deficit. Furthermore, it used its political muscle to block the early warning about its deficit that the EU Commission had mandated by the terms of the Stability Pact.

Now France is making waves. The EU's reluctant number two country has served unofficial notice that it, too, does not plan to abide by its deficit-reduction promises. This comes one year after tiny Ireland received an official warning about its fiscal policies, even though Ireland's budget was in surplus, and mightily so.

So, four years after it was signed, the Stability Pact seems to be in shambles. Indeed, Europe is now rife with talk about junking it, as well as with discussions about how to fix it. Rightly so: the Pact is ill-conceived and its implementation ill-designed.

Not only is the Pact's fixed 3% limit for the ratio of budget deficit to GDP arbitrary, but it also ignores the fact that when an economy slows, deficits increase automatically. Recognizing this fact, the Pact's architects made things worse by adopting two misguided `solutions'. They introduced a safety clause allowing a country to suspend the deficit ceiling in case of serious recession, but they went on to define a serious recession in such a way as to make such a suspension implausible in practice.