Who can afford not to stretch the budget?

Date: 01/03/01

The public brawl between the European Commission, 14 finance ministers and the Irish government over Dublin's flouting of the EU's budgetary guidelines could prove to be more than just a little local difficulty, reports Tim Jones

THE EU's German-designed economic policy rulebook is tough, relentlessly objective and built to withstand anything thrown at it.

Until anyone uses it, that is. Then, the growth and stability pact agreed five years ago in Dublin of all places turns out to be negotiable - the kind of Union fudge-machine Germany feared when it signed up to economic and monetary union.

The public brawl between the European Commission, finance ministers and the Irish government over the latter's flouting of the EU's budgetary guidelines showed how vulnerable the pact is to intense political assault.

The Union's censure of Ireland, which represents just 1% of the EU's population and annual output, still managed to produce a two-hour debate within the Commission, weeks of negotiations with the Economic and Financial Committee (EFC), texts agreed then torn up and rewritten and a public-relations war.

The attack on plucky little Ireland has shocked citizens throughout the EU and even euro-enthusiasts on the political left, who fear that 'Brussels' is using the cloak of the common currency to order public-spending cuts by national governments.

Selling euro-zone membership to Swedish and British Social Democrats just got even harder and Irish MEPs have warned that their countrymen may punish the EU by refusing to ratify the Nice Treaty in a referendum due in May.

Yet this was just a ticking-off - a formal recommendation to Ireland to change policy allowed for under Article 99 of the EU's treaty. It was the first red signal in a pact timetable that ends with fines worth up to 0.3% of gross domestic product if governments allow budget deficits to widen beyond 3% of GDP.

Admittedly, this was never Dublin's problem, since the Irish budget is in surplus to the tune of 4% of GDP, but it was the first test of the pact's early warning system to detect and remedy policy slippages. Nobody could deny there has been some. Irish consumer price inflation averaged 5.6% last year compared with a 3.1% forecast in the government's update of its EU-mandated three-year fiscal plan ('stability programme').

Since the Irish authorities no longer have control over interest rates to dampen rising prices, the Union's annual broad economic policy guidelines agreed at last spring's Feira summit specifically committed Dublin to curb spending or raise taxes to head off inflation.

Instead, Finance Minister Charlie McCreevy cut standard income tax rates from 22% to 20%, the top rate from 44% to 42%, standard value-added tax from 21% to 20% and excise duties on petrol by 4 eurocents a litre. He also raised net current spending by 6.6%, compared with the previous 4% spending-growth target, "to make more rapid progress in key social spending areas and to help secure industrial peace".

Even governments sympathetic to Ireland's extraordinary economic achievements since the 1970s felt something had to be done. "We could have argued about this for a long time but if we feel that economic policy coordination is a good thing, then we can't have a country doing the exact opposite of what it was committed to do and just walking away," says a senior EU monetary official.

Economics Commissioner Pedro Solbes's staff took the unprecedented step of writing a formal Article 99 recommendation, calling on Ireland to reverse measures in the 2001 budget. This was redrafted to avoid specific policy demands after Health Commissioner David Byrne and his cabinet intervened. When the proposal went to national treasury and central bank representatives in the EFC, Irish officials are said to have played their hand badly. Echoing McCreevy's views, they refused to see there was a problem and said they should be praised for transforming Ireland into a 'celtic tiger' - an economy growing at up to four times the EU average and producing per-capita income of 115% of the Union average.

"Their refusal to acknowledge the problem made people resistant to negotiating," said a second official.

It also allowed long-dormant resentments to surface - feelings given voice by Belgian Finance Minister and Eurogroup Chairman Didier Reynders. Between the late 1970s and early 1990s, EU fiscal transfers to Ireland totalled between 4% and 7% of GDP every year and accelerated growth by 2.5% per annum, according to government figures.

At the same time, the Irish government has enticed massive inflows of foreign direct investment with a standard corporate tax rate set to fall to 12.5% - the lowest in the EU. "If aid permits a region or a country to catch up to EU levels, people wonder if it is being abused when they see taxes or other charges being lowered," said Reynders.

This across-the-board irritation with the Irish allowed Solbes to win support for his formal censure from every government. However, at the same time but with far less fanfare, the French, Italian and British finance ministers were feeling the heat. All had received warnings, though not formal recommendations, from fellow ministers that their three-year budgetary plans may be just a tad optimistic.

Of these, the Italians should be the most worried. While Rome's 2000-04 plans were endorsed, the EU warns that rising tax revenues may not "be fully structural in character". That is, they rely too heavily on faster growth rates and not enough on improved collection and a stable tax base. Also, some measures in the 2001 budget may be "less efficient than previously thought".

Competition Commissioner Mario Monti gave an early signal to the key combatants in Italy's spring election that their tax-and-spending plans need to be "compatible with the requirements of economic and monetary union". Silvio Berlusconi, the centre-right leader now 20 points ahead in opinion polls, has promised deep tax cuts and a programme of infrastructure projects. Italy's 2001 budget-deficit target of 0.8% of GDP already looks under threat from rising euro-zone interest rates.

French Finance Minister Laurent Fabius and his UK counterpart Gordon Brown both told colleagues their decisions to introduce, respectively, a tax-cutting and a giant spending programme represented discretionary choices at a time of strong budgetary performance.

Nevertheless, after weeks of negotiations, the EFC decided to write warnings to all three governments that, in the event that they missed their targets, they would take extra measures to come back onto the path of fiscal virtue.

As the new round of guideline-drafting begins, economic policy officials fear that specific recommendations may be watered down or pulled from the text altogether to avoid creating hostages to fortune.

The Italians, in particular, have been twice-bitten by the annual audit of the guidelines. First, they had to fight their way out of strict adherence to a budget-deficit target undermined by falling corporate taxes directly attributable to slow growth. Now they have their wrists slapped over the structure of their tax revenues.

"There was a time not very long ago when people were talking about altering the code of conduct for stability and convergence programmes to be even more specific about where governments should act. But, as long as we are still fighting over every sentence and people are refusing to see the facts, it's hard to be optimistic," says an EU official.

Ireland was a stroll in the park. With world growth turning downwards, the threat to optimistic government revenue forecasts in Italy and France is real. When the Commission and the EFC decide to take these two on, then retired German Finance Minister Theo Waigel can see what his pact is made of.

Major feature. The public brawl between the European Commission, 14 finance ministers and the Irish government over Dublins' flouting of the EU's budgetary guidelines could prove to be more than just a little local difficulty.