When Bad Things Happen to Good Agreements

The EU's balanced-budget pact is starting to look out of date

It was the kind of agreement that gave Europe its reputation for newfound financial rigor. The Stability & Growth Pact, signed in 1997, required all 15 European Union nations to balance their budgets over a four-year period. Its goal was to create a sound financial footing for the euro, encourage solid economic growth, and curb the European propensity for heavy state spending. This was serious, grown-up stuff. The signers of the pact even agreed to pay stiff penalties if their deficits exceeded limits enshrined in the Maastricht Treaty.

Yet even before the terrorist attacks on the U.S., what seemed like sage statecraft was beginning to look like head-in-the-sand stubbornness. Europe's economy was slowing, and squeezing spending would depress growth further. The attacks make the situation even worse. They could plunge the world into recession and bring Europe's economy to a screeching halt. In those circumstances, trying to curb budget deficits could be dangerous, according to a growing band of European policymakers and economists. By limiting the funds governments can pump into the economy, the pact could deepen the downturn and delay the recovery. That in turn would weaken the euro--an ironic twist, since the pact was designed to give the euro some backbone. "Tightening at this stage in the cycle could do more harm than good," says Nick Eisinger, a sovereign debt analyst at Fitch IBCA, the rating agency, in London.

No surprise, then, that the hot talk in Europe's finance ministries focuses on whether and how to loosen the pact's terms. If Europe's economy swoons, as economists expect, finance ministers will have to raise taxes or cut nondefense spending--defense spending will probably increase--to meet their budget targets. But with general elections due in France, Germany, and several smaller countries next year, their governments are more interested in maintaining state spending than cutting it. On Sept. 18, France's socialist Finance Minister Laurent Fabius outraged the conservative opposition by unveiling plans to increase spending by 2% next year. On Sept. 21, Euro zone finance ministers meet with European Central Bank president Wim Duisenberg to discuss budget issues in Liege, Belgium. Insiders say there will certainly be calls to rethink the pact.

That sets the stage for a battle royal. Duisenberg told the European Parliament on Sept. 12 that the ECB would "strongly advise" against "moves to relax the form or the interpretation of the pact." The ECB argues that sound government finances will help the euro and, ultimately, encourage rather than hinder growth. Supporters of the status quo say that euro zone countries should juice their economies through far-reaching structural reforms, not bigger deficits. "We need more flexibility in the economy, not more flexibility in the stability pact," says Finnish Prime Minister Paavo Lipponen.

There's no denying that Europe's big economies need to loosen their labor laws and make other structural fixes. But even if they did that tomorrow, it would be months or years before the reforms could exert a positive impact on the economy. In any event, analysts say the big three euro zone economies--Germany, France, and Italy--are bound to breach their pact commitments this year unless they impose tax hikes or spending cuts.

BIG GAP. Thus, Germany, which strong-armed other EU governments to approve the pact in 1997, now is one of the biggest proponents of change, behind the scenes. Analysts estimate that government revenues in Germany will be 1% lower than expected this year. So there is little chance that the government can contain its budget deficit to 1.5% of gross domestic product, as it pledged to do. In France, Finance Minister Fabius is struggling to plug the gap left by an unexpected $3.5 billion shortfall in revenues this year. Italy's deficit will be double the 0.8% of GDP that Rome had hoped for because of slower-than-expected growth. "If we thought reaching the 0.8% deficit would have negative effects on the Italian economy, we would certainly want to rethink things," says Vito Tanzi, an under secretary at the Italian Treasury. "We would try to convince [Europe] that the pact should be adjusted."

Easier said than done. All 15 EU states would have to approve changes to the pact. An official memorandum stating that there is no question of changing the spirit of the pact and its commitment to sound state finances might help quell the opposition. Whatever happens, one way or another, Europe's stability pact is looking a lot less stable.

By David Fairlamb in Frankfurt

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