By George Friedman

Twenty-five EU leaders (all but those from the United Kingdom and the Czech Republic) signed a treaty March 2 committing eurozone members to increased fiscal responsibility. The "fiscal compact," as it is known, requires signatory eurozone members to enact constitutional amendments or equally binding national legislation enforcing EU-mandated budget constraints and stipulates corrective mechanisms to be automatically enacted at a national level if a country deviates significantly from these constraints. The treaty will go into force when at least 12 of the 17 eurozone member states ratify it, after which participating countries have one year to implement mechanisms to sufficiently enforce budgetary discipline.

Germany heavily pushed for the fiscal compact, demanding it in exchange for continued financial assistance to the rest of Europe. As the second-largest exporter in the world, Germany benefits greatly from the eurozone's common market and single currency, and holding the bloc together is thus a key concern for Berlin. For this to happen, member states need to have more sustainable finances, which means running a balanced budget and having low government debt. A state's failure to do so will mean unsustainable debt and defaults that, because of the eurozone's heavy economic and financial integration, puts other states at risk of default. Thus far, Germany, with the help of the other eurozone countries and the International Monetary Fund, has prevented such defaults by funding bailouts for Greece, Ireland and Portugal, but it understands that continuing to do so will be financially and politically unsustainable. Berlin would like the treaty to lay the groundwork for better budget management practices across the eurozone, but such an outcome is dubious, as evidenced by the failure of previous attempts to enforce national budgetary discipline through EU-level agreements and institutions.

Maintaining and enforcing fiscal discipline among member states has been a chronic struggle for the European Monetary Union throughout its existence, as shown by previous agreements that tried to link the eurozone's economic policies. Under the Maastricht Treaty of 1992, countries wishing to adopt the euro must first meet several economic and financial criteria, including achieving an annual budget deficit of no more than 3 percent of the country's gross domestic product (GDP) and a government debt ratio of no more than 60 percent of GDP. However, nowhere in the treaty was there a stipulation that the countries must continue to respect such criteria after acceding to the eurozone. The Stability and Growth Pact (SGP), adopted in 1997, addressed this by requiring countries to continue to adhere to the criteria for accession and mandating punitive action, including financial sanctions, for countries that fail to do so.

Enforcement of the SGP proved difficult. Any punitive proceedings initiated by the European Commission required approval by a qualified majority of the Council of Ministers -- in which the country being targeted retained its vote. This allowed it to block the sanctions with the support of only a few others, and considering that most EU countries have violated the deficit criteria at some point in the union's history, this support was not hard to find. Under the SGP, punitive proceedings have only been initiated twice, against Portugal in 2002 and Greece in 2005, and financial sanctions were not applied in either case. As of December 2011, only Finland, Sweden, Luxembourg and Estonia were not in violation of the deficit criteria.

New EU legislation was introduced at the end of 2011 to address the chronic issue of weak enforcement. Referred to collectively as the "Six Pack," these measures made it easier for EU institutions to impose sanctions on or initiate punitive proceedings against member countries for budgetary infractions. The most noteworthy legislation made it so that if the EU Commission deems a country to be taking insufficient action to correct its deficit (or simply failing to comply with EU regulations), it triggers specific, pre-determined sanctions on the country that can only be blocked by a qualified majority of member states.

Circumnavigating National Sovereignty

Though the introduction of the Six Pack legislation makes it easier for EU institutions to impose sanctions on or initiate punitive proceedings against member countries for budgetary infractions, all these reforms still face the fundamental weakness of the European Union: the unwillingness of member states to cede their own national sovereignty for the sake of European-level policy coordination. In the face of conflicting national interests, EU-level institutions and policies have consistently proved weaker. This gives the new fiscal compact its most potential significance.

Contrary to previous expectations, the fiscal compact does not actually sacrifice budgetary authority to an outsider at the expense of national sovereignty -- at least not beyond what European states had already committed to in previous budgetary agreements such as the Stability and Growth Pact. The new fiscal compact attempts to work around the political challenge of national sovereignty by requiring individual states to adjust their own laws rather than bolstering EU authority. In so doing, the treaty appears less to be forcing countries to give up sovereignty and also creates an indirect means of self-reinforcement by mandating domestic checks on individual countries' leaders. The fiscal compact does cede sovereign decisions to the European Union inasmuch as it seeks to ensure that those sovereign decisions are always aligned with EU interests.

Achieving the same fiscal outcome by having states adjust their national laws rather than by bolstering EU authority appears to be a clever way around the problem of sovereignty. However, its effectiveness cannot be judged until the European Union begins to enforce it, which will not happen for a minimum of two years. Moreover, in case of controversy the European Court of Justice will be in charge of deciding whether the constitutional reform or equivalent national law meets the desired criteria -- a process that will certainly be lengthy and controversial, especially in the beginning while precedent is being established.

The Outlook from Berlin

German Chancellor Angela Merkel has invested much political and economic capital into the fiscal compact, so she needs it to be perceived domestically as a victory. However, until signees actually begin to incorporate the fiscal compact into their national laws, Berlin likely will remain skeptical that the new agreement will achieve its intended goals.

In the meantime, Germany will use other leverage, such as its comparative wealth, to move European states toward stricter budgetary discipline. The next major issue the European Union is to debate is what to do with funds from Europe's initial bailout mechanism, the European Financial Stability Facility -- of which Germany is the largest contributor -- once the new European Stability Mechanism replaces it. The severity of Berlin's conditions for agreeing to incorporate leftover funds from the former into the latter will indicate how satisfied it is with reform efforts currently under way.


Enforcing Budgetary Discipline in the Eurozone is republished with permission of STRATFOR.

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