Charlemagne. Debasing the currency

European Union leaders tear up fiscal rules even as they fight for their new constitution

THE euro coins jingled merrily across the bar of the European Council's Justus Lipsius building in Brussels at this week's EU summit. The cash machine in the marble lobby delivered crisp new notes on demand. Three years after euro notes and coins first began to circulate in 12 EU countries, the euro is an unremarkable fact of everyday life. Yet for all that, it also remains an experiment. Indeed a deal arrived at by EU finance ministers over the weekend, and later endorsed by the summit, underlines just how experimental the single currency still is.

The agreement was, in essence, to rip up the existing fiscal rules for euro members and start again. For eight years finance ministers have steadfastly insisted that the stability and growth pact is essential to the health of their single currency. The pact's demands for fines on countries that persistently run budget deficits bigger than 3% of GDP have been defended as an essential tool to stop improvident governments from undermining the euro. But now the rules have been so loosened that they have been rendered almost entirely meaningless.

Officially, of course, this is not what has happened. This week's agreement bore the Orwellian title, “Improving the operation of the stability and growth pact”. The European Commission claims that the essential features of the pact are untouched: the 3% limit on deficits is still in place, as is the goal of avoiding a national debt bigger than 60% of GDP.

The trouble is that, largely at the behest of France and Germany, which have violated the 3% ceiling for three years in a row, a raft of possible let-outs and exceptions have now been written into the pact. Governments can now avert the threat of sanctions by pointing to any recession, however shallow, or even just to a persistent period of slow growth. And various forms of virtuous-sounding spending are to be given special consideration, including education, research, defence, foreign aid and anything that contributes to “the unification of Europe”. This last phrase was put in to appease the Germans, who argue that it is the costs of German unification that have pushed their budget over the limit. Yet when the original stability pact was adopted in 1997, Germany had already been unified for six years. Citing its effects now is, as the Austrian finance minister cruelly observed, “a bit of a joke”.

The European Central Bank clearly does not believe the reassuring spin emanating from Brussels. Shortly after the new deal was announced, it issued a statement that it was “seriously concerned”. The ECB hinted that it might respond to a new bout of fiscal incontinence in the euro area with higher interest rates. It still subscribes to the logic underlying the stability pact: that a single-currency area without a single government needs strong and enforceable rules to contain national budget deficits. The alternative, it is held, would be to risk “moral hazard”, in which a profligate government was able to spend recklessly, safe in the knowledge that the consequences of its actions, in terms of a weaker currency or higher interest rates, would be shared out among all euro members.

There is plenty of evidence that governments, knowing that the pact's sanctions are never likely to be enforced, have been increasingly ignoring the 3% limit. As many as five of the 12 euro-area countries have now breached the ceiling. The worst offender is Greece, which confirmed this week that its deficit for 2004 was a shade over 6% of GDP. But does any of this matter? The long-predicted revenge of the financial markets against either the euro area as a whole or individual countries has yet to materialise. Traders seem more preoccupied by America's twin deficits than by fiscal problems in Europe. Even as the stability pact has unravelled over the past year, the euro has risen steadily against the dollar. When EU finance ministers delivered their final coup de grace to the pact this week, the markets at last reacted - but only with a very modest fall in the euro's value against the dollar.

All dead in the long run

The most compelling arguments for the stability pact were always longer-term. The ageing of Europe's population means that public spending on pensions and health care is projected to soar over the next 30 years. If European governments cannot balance their books now, what hope do they have in future? This week Standard & Poor's, a credit-rating agency, suggested that, if current fiscal trends persisted, French debt would be rated as junk by the early 2020s. German and British (and, incidentally, American) debt would go the same way over the following 15 years. Yet this prediction contains a seed of comfort for those alarmed by the demise of the stability pact. For it makes the point that the markets are increasingly likely to distinguish between the bonds issued by different European countries. Traders could downgrade French debt, while happily buying euro-dominated paper issued by the thrifty Dutch. The moral hazard argument may be a lot less convincing than the original designers of the stability pact thought.

Such theoretical and long-term issues tend not to weigh heavily with EU leaders when they lock themselves away for a summit. Getting through the next election - or just the next press conference - is a far greater worry. This week's summit, supposedly about economic reform, was overshadowed by fears that French voters might reject the draft EU constitution in their referendum on May 29th. In response, Jacques Chirac, the French president, came to Brussels to poke gaping loopholes through a plan to liberalise trade in services. His fellow leaders duly obliged him by agreeing to rip up the draft. Nobody could reproach them for lacking zeal in protecting the EU constitution (the next stage in the European project). It is just a pity that their actions over the stability pact suggest they are unable to live with the consequences of treaties they have already signed up to.

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