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Is the EU’s Fiscal Compact the Answer?

December 9, 2011

European leaders today announced a broad set of policies in an attempt to solve the European Debt Crisis (the news release is available here).  Basically, the EU’s current solution is to deepen further integration through a “fiscal compact” that will limit member states’ flexibility in paying their bills:

  • a cap of 0.5% of GDP on countries’ annual structural deficits (i.e. the government deficit excluding interest payments)
  • “automatic consequences” for countries whose public deficit exceeds 3% of GDP
  • the tighter rules to be enshrined in countries’ constitutions
  • European Stability Mechanism (ESM) to be accelerated and brought into force in July 2012
  • adequacy of €500 billion ($666 billion) limit for ESM to be reassessed
  • Eurozone and other EU countries to provide up to €200 billion ($266 billion) to the IMF to help debt-stricken eurozone members

Much of the focus today has been the UK’s decision not to participate (see New York Times,  BBC, and The Economist stories).  This could be a potentially major decision by the UK Prime Minister, David Cameron.  His announcement increases the possibility of a “multispeed” Europe consisting of a more deeply integrated core of countries led by France and Germany, while more Eurosceptic countries become marginalized.

However, a more pressing question is “Will this new plan work?”  The second story on NPR’s Morning Edition this morning tried to answer this very question.  The answer is not very encouraging, and investors seem to agree, as the euro fell by less than a cent (0.2%) today against the dollar.  One would have expected a potentially momentous decision to cause the euro to rise.

Today’s EU announcement has two potential pitfalls:

  1. This is not a quick fix.  It will take years for governments to ratchet down spending so that deficits are only 0.5%/3% of GDP.  Most countries using the euro currently have deficits larger than 3%.  In addition, enshrining these rules in member states’ constitutions could take years to ratify, depending on the country’s internal rules.  Even increasing the powers of the European Stability Mechanism will take time, as it will not be brought into force for six months.  Who knows what will happen between now and then.
  2. A cap on deficit has been tried before.  Anyone who studies the EU with a 10 year memory would remember that the original rules governing the euro required member states to have a government deficit less than 3% of GDP.  However, the enforcement mechanism was quickly jettisoned with France and Germany violated this exact rule.  Even if countries do ratify this budget rule into their constitutions, who will enforce it?  The EU is notoriously weak at enforcing its own rules.

As a result, it is hard to say that this plan will solve the euro’s problems, especially in the short run.  To learn more about the euro, the EU Center is sponsoring two events:  “Could the euro implode?” on January 11th in conjunction with the World Trade Club of Indiana in Indianapolis and “The Euro Crisis: Sovereign Debt or External Imbalances” on January 12th  at 1:00PM in IMU Oak Room on the Indiana University Bloomington campus.

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