EMU’s flawed ‘marriage contract’

Date: 10/04/1997

WHAT do marriage, nuclear weapons and the sword of Damocles have in common?

Ask European Commission President Jacques Santer. Hailing a swift agreement between finance ministers last weekend on exactly how members of a monetary union should be disciplined for breaking the euro-zone's budgetary rules, Santer went into metaphor overdrive.

Fining fiscal transgressors as much as 0.5&percent; of their national income would certainly be harsh, he admitted, but that was the whole point.

“It is a bit like a marriage contract,” he said. “You need one but, if you read a marriage contract, it does not specify that divorce is looming or that you are going to die.

“So it is with these fines. They are like the nuclear bomb - with a similar deterrent effect since I believe and hope that these penalties will not have to be applied.”

And that was not all. “They will be a kind of sword of Damocles dangling over member states and only if there is slippage will the sword come crashing down.”

Got the message? The stability pact - now renamed the 'growth and stability pact' to make it more user-friendly - is meant to work so efficiently that fines for non-compliance will never be levied.

But if they are imposed, stability pact signatories will certainly not be taken by surprise. By the time they trooped out of the Huis Ter Duin hotel in the Dutch seaside resort of Noordwijk last weekend, EU finance ministers had crossed every 't' and dotted every 'i' of the pact. Nothing has been left to chance.

Although the Dublin summit in December agreed the framework of the pact, certain issues which had seemed peripheral but turned out to be far from it still had to be sorted out.

Chief among these was exactly how much a euro-zone member which runs an excessive deficit - that is, one worth more than 3&percent; of gross domestic product without the excuse of a crippling recession - should pay up.

It was already agreed that a member state found guilty of budgetary errors by its peers would have to pay a non-interest-bearing deposit into the EU budget. It was also known that this would comprise a fixed element of 0.2&percent; of GDP plus a variable component equal to 0.1&percent; of GDP for every full percentage point the deficit had overrun the 3&percent; target.

This would mean that the minimum deposit - which would turn into a fine after two years if the budgetary gap had not been closed - would be 0.3&percent; of GDP and the maximum would be 0.5&percent;.

In the weeks after the Dublin summit, ministers' aides got working on the small print of the pact and found a number of problems. What would happen if a government were forced to pay a deposit in year X, and then again in years Y and Z? Should fined countries and EU member states outside the euro-zone be allowed to benefit from the fines if and when they went into Union coffers?

Noordwijk found a simple answer to the first question.

In the first year, a lax government would be obliged to deposit at least 0.3&percent; of GDP with the Commission without accruing interest. If it failed to get the deficit under 3&percent; a year later, only the variable component of the deposit would have to be paid - that is, 0.1&percent; for each percentage-point overshoot.

While some among the deutschemark-bloc countries may think this rather tame, it is one of the few occasions in the stability pact debate when politicians have taken a realistic approach to a problem.

Since the maximum deposit in any given year would remain 0.5&percent; of GDP, a recidivist member state would have to run up a second-year deficit of 8&percent; of GDP to face the maximum penalty - hardly a realistic prospect.

It is much more likely that a country punished in year X would pull out all the stops to get its money back within two years, before it turned into a fine. Slapping another 0.3&percent; of GDP penalty on it would be harsh and probably counterproductive.

The second decision taken by ministers was less wise and may come back to haunt them.

As Dutch Finance Minister Gerrit Zalm put it: “All member states now agree that the proceeds of fines should only benefit the so-called 'virtuous' participating member states: those are the 'ins' without an excessive deficit.”

In practice, this would mean that the inner-core countries, such as Germany, the Netherlands, Austria and Luxembourg - or “the good guys” as German Finance Minister Theo Waigel put it - could look forward to budgetary windfalls of as much as 5 billion ecu if deposits were turned into fines.

German officials even suggested that this clause had been written into the pact with the intention of making Italy and Spain think twice about clamouring to join EMU from January 1999.

Only Greece's Yannos Papantoniou seemed to read the runes and opposed the clause. Southern solidarity, as so often happens when it comes to monetary union, evaporated and a penalty clause designed to transfer fiscal resources from poor to rich countries was approved.

“The proceeds will be distributed among the countries in the euro-zone which do not have an excessive deficit,” admitted Zalm. “What they do with that money is their affair, of course.”

With long-term commitments to spend as much as 10 billion ecu on major dike renovation and construction of a high-speed rail link to Paris, the Netherlands would be happy with such an arrangement.

Suggestions that the cash should be spent on job creation or even funnelled into favourite charities attracted ministerial chortles.

Santer himself trusted the wisdom of the treasuries. “Allocation of the funds was not discussed because that is up to member states which receive them,” he said. “They will spend this money wisely and equitably, I am sure.”

There is a hidden danger to such an arrangement that ministers either did not consider, or considered it so unthinkable that they ignored it.

It is that the good guys - whoever they may be in the future - will have a strong incentive to find a peer guilty of a budgetary transgression and turn a deposit into a fine.

If, after two years, a deposit-paying government had pushed through measures to get the deficit down close to 3&percent; but had just failed to make it, other ministers would, in normal circumstances, be tempted to commute the sentence. Perhaps they would give the prodigal country a few months and reward it for good intentions.

But with the prospect of windfall revenues of millions of euro each, the temptation will be rather different.

A good guy with a thorny local problem requiring cash up front or facing re-election would have to be a saint to avoid the temptation of applying the letter of the law.

To borrow just one of Santer's metaphors, anything can happen when a marriage turns nasty. People who were in love ten years before or, in the case of France and Germany, simply grabbed each other to stop anyone else winning their hearts, can just as easily turn against each other. When that happens, they fight for every penny.

As self-styled protector of every EU member state, the Commission might consider this when it drafts revisions to its own budgetary rules. Something a little more subtle than simply handing one country's fine to a cabal of good guys should be found.