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The most likely form of the fiscal compact now seems to be a very mild agreement requiring each country to “balance its budgets over the business cycle”. Although failure to comply would in principle lead to automatic financial penalties, it is difficult to imagine how such failure could be determined in a country like Spain. At what future point would Spain, with a persistent unemployment rate of more than 15 per cent, be required to raise taxes and cut social transfers? Ordering Spain to do so might rest with the European Commission, making it a political decision, rather than the “automatic” technical requirement that its proponents promise.
If this is the essence of the fiscal compact that is eventually agreed, it will have no predictable effect on eurozone countries’ behaviour. Its only effect will be to allow the eurozone’s political leaders to claim that they have created a fiscal union, and thus that they have moved Europe closer to the political union that is their ultimate goal.
But a fiscal union conceived in this way is completely different from how most people understand the term. In the United States, for example, the central government collects about 20 per cent of the country’s GDP and pays out a similar amount. That centralisation of taxes and spending creates an automatic stabiliser for any region that experiences an economic downturn: the affected region’s residents send less money to Washington and receive more in transfers.
There is no similar process in the eurozone, where taxes and spending occur at the national level. The centralised fiscal role in the US also allows all of the individual states to operate with true balanced budgets, modified only by relatively small “rainy day” funds.
But, although the current European political process will not create strong fiscal discipline, financial markets are likely to force eurozone governments to reduce their sovereign debts and limit their fiscal deficits. During the single currency’s first decade, private investors’ belief in the equality of all eurozone sovereign bonds kept interest rates low in the peripheral countries, even as their governments ran up large deficits and accumulated massive debt. Investors will not repeat that mistake: once bitten, twice shy.
For eurozone governments, that means that financial markets will now enforce what the political process cannot achieve. The EU’s fiscal compact, whatever its final form, will be little more than a sideshow.