The Euro Fiscal Rule

Last night, the leaders of Europe agreed on a new fiscal rule to try and save their common currency. The official statement details the rule:
"General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP."
We have computed the historical structural deficits to find out how tough the 0.5% benchmark is to achieve. As can be seen on the table below, among the fifteen major eurozone countries, only three countries (Belgium, Finland and the Netherlands) have managed to pass this rule succesfully (the green cells) in the last 9 years, and only one (Finland) has managed to pass it continously. Most countries have been far off the rule.

Eurozone Governments' Structural Balance (computed from IMF data)
Taking 30 years of data, we can see on the figure below that every single year, the vast majority of Eurozone countries have broken the "fiscal rule", even during periods of robust economic expansion.
Number of Eurozone countries complying and not complying to the new "fiscal rule" (IMF data)
To conclude this empirical analysis, the "fiscal rule" will likely be strongly binding for nearly all Eurozone countries. This means that, if enforced properly - and this is likely to be the case as it is planned to become constitutional law - the fiscal law will have significantly negative impact on economic growth. So what is the point of this law?

The reasoning behind this agreement is that by making such a strong commitment of fiscal rectitude, the markets will have more confidence in the debt issued by member countries and interest rate on the government bonds should go down. Such a rule should actually have been implemented directly at the creation of the monetary union. Having not done so had the consequence that member states knew they could borrow excessively and then ask the union to help them pay back their debt. This incentive problem is called free riding in economics.

Is this rule realistic?

As the data on the table show, the benchmark of 0.5% structural balance to GDP will be extremelly difficult for European countries to achieve. By setting such an ambitious rule, European governments risk missing their own targets and therefore undermining the credibility of the rule. My opinion is that they should set intermediary less ambitious goals, especially taking into account the fact that growth in other regions of the World is very slow at the moment.

Will this rule save the Euro?

This rule will help close an incentive problem in the Euro mechanism, but it is by no means sufficient to solve the current crisis. In particular, the problems of debt overhang and lack of competitiveness of the weaker countries of the Eurozone also have to be addressed.

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