Angela Merkel and Nicholas Sarkozy spent Tuesday (16 August) mapping the future of the Euro Area (EA) and apparently came away pleased with their work. The good news is that they want to move towards serious EA economic governance and seemed to have agreed on a Tobin tax as part of the deal. The bad news is that they want all members of the EA-17 to write a ‘balanced budget’ rule into their constitution; ie, to replicate the German ‘debt brake’ (Schuldenbremse) law across the EA. It won’t work.
The reason a generalised balanced budget rule won’t work is simple; it follows from the basic national accounting savings balances. Because (over the business cycle as a whole) the private sector normally runs a savings surplus, a government balance of zero logically entails a current account surplus. While this may hold true for Germany, it cannot be true for all EA countries taken together.
For the EA as a whole, one country’s exports are another’s imports—for some countries (like Germany) to run a surplus, others must run a deficit. This is not an empirical matter but follows logically from national accounting definitions; Merkel and Sarkozy are guilty of a basic fallacy of composition.
There is only one way a ‘balanced budget rule’ might work for the EA as a whole—each EA deficit country would have to run a countervailing surplus with the non-EA world. But there are two problems here. The first, shown in a paper by Whyte, is that there is not enough excess demand in the rest of the world to absorb the extra EA exports. Even if there were, the resulting global trade imbalance would result over time in the EA accumulating excess reserves, much as China today.
Crucially, Mrs Merkel and Mr Sarkozy made no mention of strengthening the ‘bailout fund’ or issuing E-bonds. The latter is vital if short-term crisis is to be avoided.
In a sane world, the German Chancellor and the French President would sack their economic advisors who clearly lack an understanding of basic economics or national accounting principles. Sadly, the world is growing less sane by the day. The financial markets will know this and soon enough return to speculating against member states’ sovereign debt.
* This piece was first published by the EU Observer; see http://blogs.euobserver.com/irvin/?p=406.
 The ‘savings balance’ identity is normally written (I-S) + (T-G) = (X-M) where (I-S) is the ‘private sector balance, (T-G) is the public balance and (X-M) is the current account of the Balance of Payments.
 See Whyte, P (2010) ‘Why Germany is not a model for the Eurozone’ London: Centre for European Reform.