Sunday, November 30, 2003
Stability pact's failure may set off EU power struggle
Posted by David Smith at 06:26 AM
Category: David Smith's other articles

On Tuesday in Brussels, euroland’s two heavyweight economies, France and Germany, did what many have said should have been done years ago. They buried Europe’s stability pact.

The pact, originally proposed by Germany ahead of the euro’s launch five years ago (at French insistence the words “and growth” were added), has had a short and turbulent life.

It was intended to ensure that countries stuck to the fiscal discipline they were required to demonstrate in the run-up to monetary union — the Maastricht treaty required that prospective members keep their budget deficits below 3% of gross domestic product — but it backfired badly.

The stability pact, as put forward in the mid-1990s by Theo Waigel, then German finance minister, was intended to solve the so-called free-rider problem and it was aimed at countries like Italy, which had a history of fiscal indiscipline.

The fear was that, once inside the euro, such countries would allow their public finances to let rip, free-riding on others, “contaminating” the euro with big budget deficits and turning it into a soft currency.

Instead, Germany and France have proved to be the euro’s weakest fiscal links. When they met in Brussels, euroland’s finance ministers had a choice. They could vote to force Germany and France to cut their budget deficits below 3% of GDP or, under the terms of the pact, face fines of up to 0.5% of GDP.

Or they could decide to ignore the rules which, by a majority, they voted to do. Those in the minority attacked the decision. Gerrit Zalm, the Dutch finance minister, said some countries had been “intimidated” by France and Germany. Josť Maria Aznar, Spain’s prime minister, said: “Today is not a good day for Europe, nor is it a good day for the European economy.”

The French government responded by saying that if Spain were not in receipt of large-scale fiscal transfers from Brussels, it, too, would be in breach of the rules.

Waigel, the pact’s godfather, also mourned its passing last week, criticising his successor, Hans Eichel. “I wasn’t disappointed. I was outraged that Germany, which was responsible with other countries for getting the pact through, should disregard it in this way,” he said.

Jean-Claude Trichet, president of the European Central Bank (ECB), warned that “non-disciplined fiscal policies ... could soon lead to inflationary pressures”.

When politicians abandon the rules, the stage is surely set for a currency crisis. So why was the euro stronger last week, hitting an all-time high of more than $1.20? And why aren’t the European financial markets panicking?

“All this has been going on for so long, the markets got bored with it,” said Glenn Davies, an economist with Credit Lyonnais Securities. “Everything economists warned about regarding the stability pact has come true, and nobody is particularly surprised.”

Anthony Thomas an economist at Dresdner Kleinwort Wasserstein, said: “Politicians were never going to vote to discipline themselves. This may be a political problem but it is not an economic one.”

The ECB, despite its public warnings, is not going to raise interest rates from 2% in response to the pact’s demise. While the ECB may be more unwilling to cut, few in the markets expected a reduction.

So what are the likely consequences? One effect will be that the 10 new entrants to the EU, mainly from eastern Europe, who have been told they must display fiscal discipline before entering the single currency, may now be reluctant to do so.

There is also greater interest in Europe in Britain’s fiscal rules. When Gordon Brown claimed the superiority of his own golden rule (borrow only to finance investment) and the sustainable investment rule (keep debt below 40% of GDP), his EU counterparts tended to scoff. Now some are starting to say Britain’s rules offer the kind of flexibility the euro area needs — although having broken one set of rules there is no guarantee they will stick to another.

The biggest long-term impact could be on relations between the European commission and individual member countries. The commission pushed strongly for sanctions to be applied under the terms of the pact and was rebuffed.

“The bitterness over the French and German budget deficits could engender one of the more dangerous stand-offs in EU affairs,” said Stephen Lewis at Monument Securities. “What started off as an economic matter is turning into a constitutional struggle over the question of where authority ultimately lies in the EU.”

The commission continues to push for closer integration. Last week, after a decade and a half, an EU takeover code was finally agreed. Brussels continues to push for tax harmonisation and is concentrating its efforts on corporate taxes. The latest draft EU constitution, to be discussed by national leaders next month, continues the federalist push.

But the suspension of the stability pact shows what some countries think of EU rules. A victory for common sense was a big defeat for the integrationists.

From The Sunday Times, November 30 2003