Will Europe's Fiscal Compact Help Avoid Future Economic Crises?

The eurozone crisis has focused attention on what caused it, how it can be handled and what can be done to avoid future crises. Against this background all but two member states of the European Union have signed a draft treaty, the 'fiscal compact', that seeks to eliminate structural fiscal deficits. This paper critically examines the theoretical logic behind the compact. It also empirically estimates the relationship between fiscal deficits and economic crises in Europe. It concludes that economic crises, measured in terms of output shortfalls, have had little to do with public sector deficits. Private sector deficits and crises in the banking sector appear to be more important. The paper also identifies a number of flaws in the design of the compact and argues that it will do relatively little to ensure that future crises are avoided. The fact that in spite or these reservations the agreement was signed reflects the significance of a particular combination of contemporary political economy factors.