ISSN 2039-2117 (online) ISSN 2039-9340 (print) Mediterranean Journal of Social Sciences MCSER Publishing, Rome-Italy Vol 5 No 14 July 2014 11 Assessing the Impact of the European Fiscal Compact on Eurozone Mediterranean States (With A Focus on Malta) Dr Philip von Brockdorff Prof Joseph Falzon University of Malta Doi:10.5901/mjss.2014.v5n14p11 Abstract The paper assesses the impact of the European Fiscal Compact on Eurozone Mediterranean States with a focus on Malta by estimating deviations between potential and actual GDP for the Maltese economy, comparing the cyclical components of public revenues and expenditure, and estimating the cyclically adjusted deficit in excess of the requirement of 0.5 per cent structural deficit. A discussion on the structural nature of Malta’s budget deficit ensues. Finally, by comparing public debt ratios of the selected States, the paper examines the policy implications of reducing the budget deficit for the Maltese Islands. Keywords: Fiscal Compact; budget deficit; potential output; actual GDP; cyclical components of public revenue and expenditure; structural deficit; public debt. 1. The Fiscal Compact: The Objectives The European Fiscal Compact is part of the Treaty on Stability, Cooperation and Governance in the Economic and Monetary Union. It binds all EU countries except for the UK and Czech Republic. The need for strong fiscal discipline is highlighted by the Treaty which in the event of default by subscribing Member States will result in automatic penalties. In other words, enforcement of fiscal discipline has become the order of the day. In fact, the Treaty puts the onus on Members States to balance their budget or aim for budget surplus. Thus, the annual structural deficit should not exceed 0.5 per cent of GDP. To achieve this, Member States will be required to introduce a target for a balanced budget and this will be enshrined in the Constitution of subscribing Member States. This implies that Member States will be liable to legal action by the European Commission in the event that this target is not reached. The deadline for this legal requirement is one year after the entry into force of the Treaty. In the event that the public debt is well below the 60 per cent mark and the Commission deems that the long-term sustainability risks of public finances in a Member State are low, then the structural deficit may reach up to 1 per cent of GDP. 2. Will the Fiscal Compact Suffice for A Smooth Functioning of the Monetary Union? The legal requirements of a 3 per cent of GDP budget deficit ceiling and the 60 per cent of GDP ceiling for public debt have existed since 1992 in line with the Maastricht Treaty. Despite this, almost all Members States have registered budget deficits and public debts well beyond the 3 and 60 per cent mark. Again, despite the Stability and Growth Pact signed in 1997, aimed at bringing medium-term structural budget balance close to balance or surplus, this too was largely ignored. The fact that no enforcement measure was adopted may have been the cause for this continued flouting of rules by most Member States but there was no real commitment to fulfill the obligations as set out in the Maastricht Treaty and in the Stability and Growth Pact. The new fiscal pact aims to address this by triggering an automatic correction mechanism and penalties in the event that a Member States is adjudged to have exceeded the limits. This may seem as the last course of action to take for a Eurozone or currency union which shares a monetary policy but not a fiscal union. When one considers that history has shown that successful monetary unions have happened when monetary union has been combined with fiscal union (as has been the case in the United States, Canada, Germany and Switzerland) agreement on a European Fiscal Compact appeared inevitable. In fact, Bordo, Markiewicz, and Jonung (2011) claim that, in order to be successful, a monetary union needs an independent central bank with price stability as one of its main objectives; it also needs free trade movement of capital