European leaders have agreed on a new plan to help deal with the sovereign debt crisis. Much has been written elsewhere. For example, Mohamed El-Arian presents his perspective in "Neither a Quick Nor Comprehensive European Fix." Some of the details are discussed in a Bloomberg article, "Europe's New Budget Rigor, ECB's Challenge."
The main point of the agreement was the use of a fiscal rule, limiting the annual structural budget deficit to no more than 0.5% of GDP. What does that mean? A structural budget deficit is what the budget deficit would be if the economy was operating at full employment (for those who remember their economics, it's when the economy is operating at its potential). When an economy is in recession, tax revenues decline due to declining income (and thus lower income tax revenue) and lower revenue from value-added taxes (similar to a sales tax; declining sales results in less tax revenue). In addition, social welfare benefits rise as more people lose jobs and poverty rises. Thus, budget deficits rise during recessions even without any new stimulus programs or change in policy. The new budget rule would allow governments to run budget deficits, but limit them to the effects of the business cycle. During good economic times, the government would need to balance the budget or even run a surplus, if the economy is exceptionally strong (resulting in rapid growth in tax revenues and less spending on social welfare).
Similar rules are already in place elsewhere (for example, Brazil and Chile) and is currently being phased in Germany (takes full effect in 2016). Balancing the structural budget instead of the regular budget allows for some flexibility while keeping the budget deficit from getting too high. Most economists oppose requiring annual balanced budgets since it would deeper recessions (imagine if the US government had to implement $1.3 trillion in tax increases and/or spending cuts immediately; the short-term economic effects would be very painful and would not achieve a balanced budget due to declining incomes and more people being pushed into poverty). However, allowing budget deficits to get out of control clearly is not advisable.
One problem with balancing the structural budget is to determine what it is. How much does tax revenue decline or spending increase due to a recession (as opposed to changes in economic policy)? Countries with fiscal rules typically delegate the responsibility to estimate the structural budget to independent authorities to minimize political influence. Thus European officials would need to choose an independent authority in order to implement their agreement. Some critics would also say that it doesn't allow the government enough discretion to deal with recessions since stimulus programs (whether in the form of tax cuts or spending increases) would less likely unless the government had been running structural surpluses prior to the recession. Recall that under the proposal, structural deficits are limited to 0.5% of GDP. For example, if the government was running a structural surplus of 1% prior to the recession, it would be able to enact a stimulus of about 1.5% of GDP each year (the equivalent of $225 billion in the US economy today) and still satisfy the rule of no more than a 0.5% structural deficit. If it was already running a structural deficit of 0.5%, there wouldn't be room for any special stimulus program.
Does this solve the problem in Europe? Not even close. If it does work, it provides a framework to reduce the likelihood of future sovereign debt crises, but does not directly address the current crisis.
