Budget Treaty: Neither Panacea Nor Poison

As German Chancellor Angela Merkel sees it, Europe's new "fiscal compact" on budget discipline will turn the euro zone into a more-perfect currency union.

Critics see it as a distraction from the real roots of Europe's debt crisis, and as a straitjacket that will condemn Europe to eternal austerity and stagnation.

Most likely, it will do neither. The proposed treaty doesn't overcome doubts about the euro zone's long-term viability and membership, and its constraints on government budgets aren't as tough as they appear at first glance.

The treaty, which is due to be formally signed in early March by leaders of euro-zone countries and any other European Union nations that want to take part, obliges governments to balance their budgets and reduce public debt. So-called structural budget deficits, adjusted for economic up- and downturns, are to be capped at 0.5% of gross domestic product. Euro members have to write that rule into their national laws or constitutions, or else EU judges can fine them.

The 0.5% deficit limit would, if obeyed, mark a revolution in European governments' fiscal policies, ending more than 30 years of steadily rising public debt in much of the region. Critics fear it is too rigid, and would rob countries of the ability to spend their way out of future recessions.

In fact, the draft treaty allows plenty of fiscal elbow room, belying complaints that it would make Keynesian stimulus policies illegal. A "structural" budget balance allows for deficits to rise automatically in hard economic times, through higher social spending and lower tax revenues, provided the government saves money in good times.

In addition, the treaty says that structural deficits will be calculated "net of one-off and temporary measures." Stimulus measures to boost demand in times of recession are supposed to be temporary anyway. And the treaty allows for even-more deviation from a balanced budget if a downturn is "severe," which other euro-zone rules define as a GDP decline of more than 2%.

"The inability of weak sovereigns to fund themselves will lead to a prolonged period in which the bias is toward fiscal tightening across the euro area," Mr. Saunders said.

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