How Effective is the European Fiscal Compact? Important Signaling Effects in the Battle Against Public Debt

The EU's heads of state have agreed on a fiscal stability treaty for Europe. One aim of the treaty is to stem the excessive public debt levels in many eurozone countries. We spoke with Friedrich Heinemann, the head of the Research Department of "Corporate Taxation and Public Finance" at ZEW, about the extent to which the treaty will encourage sound fiscal policy.

PD Dr. Friedrich Heinemann is the head of the research department of Corporate Taxation and Public Finance at ZEW. His primary research interest is empirical public finance. He also investigates questions related to fiscal competitiveness and federalism in Europe. In 2010 he completed his Habilitation at the University of Heidelberg, where he teaches macroeconomics. Alongside his involvement in various economic working groups, Heinemann is a board member of the Arbeitskreis Europäische Integration e.V. ("Committee on European Integration") as well as a member of the Academic Directorate of the Institute for European Policy in Berlin.

Can the European Fiscal Compact solve the debt crisis?

Not in isolation. The European debt crisis can only be contained with a variety of measures in a protracted process. To actually solve the crisis, perhaps a decade is needed. Nevertheless, the Fiscal Compact will make an important contribution to the development of an overall solution, as it contains stringent debt limits for participating EU nations. The most prominent feature of the Compact is its signaling effect: It tells capital markets that Europe is attempting to truly address its debt problems.

The existing Stability and Growth Compact was supposed to have ensured the fiscal discipline of EU nations. It has not been successful, however, as shown by the current debt crisis. Why might the Fiscal Compact be successful where the Stability and Growth Compact failed?

The belief that the Fiscal Compact alone can stop debt creation is naive. The Compact has weaknesses. For example, sanctions against violators remain excessively weak. Yet the Fiscal Compact does help to create new environmental conditions for national fiscal policy.  As it is now clear that private investors will bear losses in an event like the Greek insolvency, capital markets can be expected to exert considerable pressure on EU nations to engage in sound fiscal policy. If an EU country presents a disappointing budget, higher interest rates are sure to follow at the next bond issue. The Fiscal Compact provides yet another incentive for sound fiscal policy. Overall, these changes in combination are sure to encourage greater spending discipline.

In Germany there is a broad consensus that the government must spend less. But can the Fiscal Compact – which contains a "debt brake" based on the German model – impose discipline on countries where this consensus does not exist?

Researchers at ZEW have analysed this question empirically.  Our research shows that countries with a strong consensus concerning the need for greater spending discipline have more frequently passed debt limits in the past. Against this backdrop, there may be some skepticism as to whether rules developed supra-nationally and imposed from outside are as effective as rules developed voluntarily within a given country. Yet our research also offers reason to be hopeful. Particularly in countries with a low level of consensus concerning the need for spending discipline, fiscal rules can generate a new political equilibrium and encourage greater fiscal responsibility.

What historical experiences are relevant with regard to the enactment of the Fiscal Compact as it is currently designed?

The Fiscal Compact requires all signatory nations to introduce a debt brake that allows a maximum structural deficit equal to 0.5% of GDP. Experience shows that political actors can be extremely creative when it comes to the window dressing of budgets. In this regard, transparency is essential in order to quickly expose budget trickery. However, of additional importance is that Europe does not undermine incentives for responsible fiscal policy by expanding guarantees on national debt. Germany's federal system demonstrates that such mutual and unlimited guarantees create destructive incentives. Guarantee constructs based on joint and serveral liability (i.e. eurobonds) must therefore remain off the table.