Europe Misses the Mark with its Fiscal Compact

Even if the EU’s proposed fiscal treaty were realistic, it would still fail to createthe institutional foundation Europe needs to cure its financial ills.
There is an old fable about a Russian minister who, anxious to impress Empress Catherine II on her visit, erected hollow façades of villages all along her route. They were known as Potemkin villages. Today, European ministers are busy erecting their very own Potemkin villages. They call it the “fiscal compact,” and the people they seek to impress are those in the financial markets. It seems to be working so far, but soon enough someone is going to peek behind the façade and discover just how hollow the compact really is.Earlier this month, twenty-five European Union nations (Britain and the Czech Republic opted out) agreed to sign a new treaty—the “fiscal compact”—which would compel them to enshrine balanced budget amendments in their constitutions. These amendments would require countries to keep structural deficits—that is, deficits not caused by short-term factors such as recession—below 0.5 percent of GDP and headline deficits below 3 percent. Countries that violate these rules are supposed to be brought before the European Court of Justice and fined up to 0.1 percent of GDP (about $3 billion for a country the size of Greece).At first pass, these rules seem quite firm. Closer analysis exposes their shaky foundations. For one, the rules are simply impractical—just three of the seventeen eurozone countries meet the proposed fiscal criteria today. Even Germany, the supposed pillar of fiscal rectitude, has broken the 3 percent ceiling seven out of the last eleven years. Moreover, the pact is unenforceable. A structural deficit is a theoretical concept that is difficult to quantify. There is no consensus of what qualifies as a “short-term” factor—ask a dozen economists what the structural deficit of the United States is today and you are likely to get a dozen answers. If this rule wasn’t slippery enough, the treaty also has an escape clause that permits governments to break these rules under “exceptional circumstances”. It wouldn’t take much wriggling to get out of these strictures. Realistically, these rules are not binding.Additionally, the European Union has been here before. The Stability and Growth Pact (SGP), signed in 1997, was supposed to restrict deficits to 3 percent of GDP and debt levels to 60 percent of GDP, promising to fine violators. However, these criteria were quickly violated by virtually every member state, including Germany and France, and have been violated repeatedly since. Yet, not a single fine has ever been levied. Perhaps this is for the better. After all, what good does it do to fine a country that is already short on cash? Look at the IMF packages, which also demanded fiscal rectitude, and see how they fared. Both Greece and Portugal failed to meet their deficit reduction targets in both 2010 and 2011, and are expected to do so again in 2012. Only Ireland has succeeded. In short, neither fiscal austerity nor enforcement has a very good track record in Europe.Even if the treaty were enforceable it wouldn’t resolve the current crisis or prevent the next. Neither Ireland nor Spain—countries now forced to pay punishing rates to obtain financing— broke the SGP prior to the crisis, and over that same period, Portugal’s deficits were on average no larger than Germany’s. Greece was a bad apple and is not representative of Europe’s problems, which are, fundamentally, an imbalance between the core and the periphery (the periphery has insufficient savings to finance the amount it wishes to spend) and the competitiveness gap which causes it.It is true that if core countries (mainly Germany) continue to provide funds to the periphery, there will need to be checks in place to ensure that spending on the periphery does not get out of control. However, the “fiscal compact” is not the way to achieve this. What is needed instead is joint control over budgets and a mechanism to ease adjustment through the transfer of funds from strong to weak economies. In short, the EU needs a real fiscal union like the United States. Germany recently made a proposal that met the first criteria at least—requesting that Greece cede control over its budget—but the plan was called “impossible” and rejected. Clearly, the EU lacks the will to take the necessary steps. In the meantime, they should be careful not to delude themselves into thinking that this treaty is a substitute for a real fiscal union.European policymakers can put up all the façades they want; it won’t change the fact that their institutional foundation is unsustainable. This treaty does nothing to address the lack of a true fiscal union with oversight and transfer mechanisms. If they want the euro to survive they will need to start building foundations behind their façades, and quickly.