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.

The aim is to fix Europe’s long-term fiscal problem, which has been exacerbated by three factors: the failure, since the euro’s inception, of the eurozone-wide Stability and Growth Pact (SGP) to enforce deficit and debt limits; the crisis that erupted in Greece and other countries on the eurozone periphery in 2010; and the various bailouts that have followed. There is no reason to doubt that the member states will follow through and adopt national rules by the end of the year. The problem is what comes after that: the risk that the fiscal compact will founder on precisely the same shoals as the SGP.

Ever since the eurozone was established, its members have issued 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 it is elsewhere.