Europe’s stability and growth pact: Loosening those bonds

Date: 19/07/03

Europe's governments are wriggling free of the stability pact's constraints

WATCHING the governments of the euro zone dealing with its stability and growth pact is a little like watching an escapologist struggling free from a tight knot of rope. With each successive move, there is a growing sense that it is only a matter of time before they break loose.

The rules of the pact are exceptionally complex, but the principles are simple. In normal times all members of the European Union are meant to aim for budgets that are “close to balance or in surplus”. Governments that run fiscal deficits bigger than 3% of GDP must take swift corrective action. And if any of the 12 countries that have adopted the euro breach the 3% limit for more than three years in a row, they may be liable to fines of billions of euros.

These provisions were meant to be so intimidating that no government would dare breach the 3% rule. It has not worked out like that. Last year France, Germany and Portugal all broke it; and France and Germany are certain to do so this year again. This week Francis Mer, the French finance minister, told his European colleagues that France was likely to break 3% next year too. The Germans still claim they will be below 3% in 2004, but their growth projections look rather optimistic.

European officials and politicians see a train crash coming and are starting to take evasive action. This week Jacques Chirac, France's president, called for the pact's “temporary softening”. A group convened by Romano Prodi, the European Commission's president, has also just called for a modification of the conditions under which the 3% line may be breached.

But the pact's defenders are not giving up. The Austrian, Irish and Dutch finance ministers have all called for the letter of the stability pact to be observed and they have supporters in the European Central Bank and in parts of the commission as well. The diehards fear that if the pact is indeed modified, then all attempts to impose fiscal discipline in the euro area will be imperilled. The consequence, they fear, would be a surge in government deficits and bitter political recrimination.

Although some of the pact's defenders acknowledge privately that it is highly unlikely that EU governments will ever really vote to impose those fines of billions of euros on Germany or France, they believe there is an earlier line of defence. Next year the EU's finance ministers could vote to impose binding recommendations on countries that have persistently breached the 3% limit. The hope, probably misplaced, is that Germany and France would then impose the necessary austerity measures.

But would that make economic sense? Japan in the 1990s and the United States now have reacted to slow growth by ramping up their budget deficits. The OECD is forecasting that this year America's deficit may hit 4.6% of GDP and the Japanese one may still be as high as 7.7%. Many economists agree that it makes little sense to force European governments whose countries' economies are nearly in recession to slash public spending.

So how could the pact best be modified? Several ideas are doing the rounds. One is to exempt certain types of government spending, for instance, on research and defence, from deficit calculations. But this is casuistry: spending is spending. Another idea is to widen the 3% limit - perhaps to 5%. Alternatively, the conditions under which a breach of the 3% rule is allowed could be changed. Rather than being an inflexible barrier, it might be adjusted according to the economic cycle.

Perhaps the best option would be to concentrate on levels of government debt rather than on annual deficits. A breach of the 3% limit is a more serious matter in a country like Italy, which still has government debts of over 100% of GDP, than in Germany or France, where the national debt is relatively well under control.

All these would-be solutions, however, raise problems of their own. The current rules are written into European law. Getting agreement to change them would require the consent of most EU governments. But those countries that have been virtuous over deficits will be reluctant to give leeway to the malefactors.

Meanwhile, economists at the European Commission worry that, if governments cannot control state spending in present circumstances, they will face an explosion of deficit spending in decades to come, as pensions costs soar. Ultimately, that could threaten the very viability of the euro. Such concerns are entirely fair. But the answer is for governments like those of France and Germany to get serious about structural and pension reform. Forcing their economies into recession through an austerity drive now will do nothing to solve the euro zone's long-term problems.

Europe's governments are wriggling free of the Stability Pact's constraints.