Europe’s single currency. The instability and fudge pact

Why it is right to water down the rules for the euro

EUROPE'S finance ministers, like their counterparts everywhere, usually crave discipline and clarity. Yet this weekend they will be discussing a plan by the European Commission to make the “stability and growth pact”, the set of rules that are supposed to limit budget deficits run by countries in the euro, less firm and more fuzzy. Somewhat counter-intuitively, they would be wise to welcome the proposals - although they also need to find better ways to instil fiscal discipline.

There are two huge problems with the existing pact. To impose a rigid rule that budget deficits should never exceed 3% of GDP save in the deepest of recessions was foolish economics, for a monetary union needs more fiscal flexibility, not less. And to support the rules with sanctions that could turn into fines as big as 0.5% of GDP was idiotic politics. Even when the rules were drawn up, it was predictable (and was predicted, by this newspaper among others) that they would never be enforced. This remained true even after the commission in July won a court ruling that France and Germany had broken the law by persuading their colleagues to “set aside” the pact, rather than sanction them for breaching that 3% ceiling.

The commission now plans to be more flexible over such breaches. It will take into account not just recessions but lengthy periods of slow growth. It will consider the sustainability of countries' public finances, paying more attention to overall debt burdens, and to long-term liabilities such as pensions, than to a single year's deficit. Countries will be given longer to bring deficits down. Although the formal provisions for fines will remain, as they are enshrined in treaties, the implication is that in future nobody will try to impose them. Instead the system will work through peer pressure.

Several central banks are unhappy about a weakening of the rules. This week the German Bundesbank blasted the commission's plans. The European Central Bank has also said it sees no need for changes in the pact. Some finance ministers may agree, especially those who accused France and Germany of applying the law to the small and meek but not to the big and powerful. If enough say no to any change, the pact will continue as it is. Yet as one finance minister puts it succinctly: “The worst possible combination is strict rules, severe sanctions and no credible enforcement.”

The question is, will peer pressure be enforcement enough? Despite what France and Germany did last year, finance ministers do genuinely seem to be trying to hold down their deficits. Italy has made strenuous efforts to stay under 3%, for example, even if its government has included several one-off dodges such as tax amnesties. But the best hope should be that peer pressure is supplemented not by theoretical fines, but by a more potent practical threat: the financial markets.

An oddity of the first few years' experience of the euro has been that markets seem to have distinguished so little between the creditworthiness of different countries. The prospect of a default by any euro member is, of course, remote. But fiscal discipline would be stronger if it was clearer that it is not wholly inconceivable - and that neither the ECB nor anyone else would stand behind potential defaulters. The downgrade in Italy's credit rating last July was salutary. If ministers and central bankers want to reinforce budget discipline, they should stand up and repeat loudly the provisions of the Maastricht treaty that forbid any bail-out of national governments - and let markets draw the appropriate conclusions.

Editorial feature which argues that, on balance, it supports the European Commission's proposals 'to water down the rules for the euro' in its September 2004 communication on economic governance.

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