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Germany, France ready the strait jackets Add to ...

Germany and France have agreed on a solution to the European debt crisis: fiscal strait jackets.

German Chancellor Angela Merkel and French President Nicolas Sarkozy envision automatic penalties for the profligate and debt limits in the constitutions of each of the euro zone’s 17 members. The hope is that this will be enough to convince the European Central Bank that it can step up purchases of European sovereign debt. The central bank is extremely reluctant to bail out governments without some certainty they will start taking budget policy seriously.

So far, so good.

Research by the International Monetary Fund suggests that fiscal rules tend to have a positive correlation with improved budget discipline. This is especially the case when governments lose the faith of financial markets. The promises of European politicians count for little at the moment. They now have to back up their deficit-reduction pledges in writing.

But it’s only one step. An impressive balance sheet isn’t always enough to ward off a financial meltdown.

Ireland, one of the three European countries that needed a bailout, was one of the few countries that consistently played by the budget rules the European Union already has in place. Ireland had a budget surplus of 1.7 per cent of gross domestic product in 2005 and 2.9 per cent of GDP in 2006.

The current EU rule demanding budget deficits no wider than 3 per cent of GDP is toothless, but that didn’t seem to matter in the case of Ireland. Same for Spain, which is struggling to avoid Ireland’s fate. The country ran a budget surplus of 1.3 per cent of GDP in 2005; 2.4 per cent of GDP in 2006; and 1.9 per cent in 2007. (For a complete table of general government balances in Europe, click here.)

“The fact that Ireland and Spain were among the few countries that honoured their stability and growth pact obligations has been conveniently forgotten in this drive toward the ‘stability union,’” observed Sony Kapoor, managing director of Re-Define, a London-based economic research outfit.

Constitutional commitments to keep deficits small and debts manageable will at best buy political leaders some breathing room from bond traders. A lasting fix will require getting their populations on side for the structural changes that will be necessary to end chronic budget deficits.

That will be hard and it will take time.

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