So Much for Europe's Fiscal Discipline

The EU is facing a crisis as budgets balloon and nations square off

Fiscal probity above all. That was the do-or-die pledge made by European heads of government at a meeting in Barcelona just last March. One by one, the key nations of Europe solemnly agreed to balance their budgets by 2004, even if it meant telling voters that generous benefits had to be cut. Welfare state largesse is nice, but balanced budgets translate into lower interest rates, investor confidence, a strong euro, and good growth. All that is needed is a little discipline. It's the next step in building a stronger Europe, a more united Europe.

Fat chance. Already, Germany, France, Portugal, and Italy are having problems reining in large budget deficits, mainly because of a stronger-than-expected economic downturn in the euro zone last year and an anemic recovery this year. The ever-vigilant European Commission triggered a kind of early warning mechanism in February by threatening to issue a formal reprimand to Germany and Portugal about their bulging deficits--which are fast approaching the 3% of GDP that is the ceiling for all euro zone countries.

Political pressure from Berlin, along with pledges to rein in spending, have forestalled punitive measures in Germany's case. Portugal, too, escaped rebuke, since its center-right government has promised to enact austerity measures. Yet the struggle for a new, more responsible Europe is far from over. In fact, it's just heating up. Since the high-water mark of European unity in 1992, when the Maastricht Treaty put the finishing touches on monetary union, European leaders have been postponing crucial decisions. From fiscal discipline and rules for bringing in new EU members, to new power arrangements in Brussels, "the problems are now coming home to roost, and it's all looking a bit unpleasant," says Charles Wyplosz, director of the International Center for Monetary & Banking Studies at the University of Geneva and an adviser to the French government.

That's an understatement. Things are getting downright nasty. Start with the core relationship in Europe--the nexus of power and authority that connects Germany and France. The two countries once set the pace for reform in Europe. Now, instead of planning with Paris how to restore the momentum on reform, the Germans are accusing the French of being the biggest budget-busters around. On May 14, only hours before French President Jacques Chirac's new Foreign Minister, Dominique de Villepin, was set to land in Berlin, German Finance Minister Hans Eichel launched an unprecedented public attack on Chirac. The French President plans to stimulate the economy through more government spending and tax cuts--even if that breaks commitments to the rest of Europe to balance the books. "I don't see how Chirac can vote [to balance France's budget], and then say a month or two later it no longer applies," said Eichel. "If the French don't toe the line, all the euro zone states could lose credibility in the markets." In private, German government officials have been even more scathing. "France has lost the political leadership of Europe," says one aide to Chancellor Gerhard Schröder.

Chirac is trying to repair the damage by renewing his pledge to rein in France's budget deficit. But the reality is that he must fulfill his campaign promise to cut 5% off French income taxes. Given this political bind, it's hard to see how Paris can balance the books before 2007. Such a delay would clearly violate the Growth & Stability Pact, the treaty everyone signed to ensure fiscal discipline. The Germans are left wondering why they should hold up their end of the bargain. "It's bizarre that we and the Portuguese are trying to cut spending, whereas the French want to ride roughshod over the pact," says an aide to Eichel.

Consumers and companies across the euro zone could end up paying the price. Already, yields on short-term euro zone government bonds have jumped by up to 10 basis points over the past month on fears that squabbles over budget deficits, coupled with higher-than-expected inflation, could force the European Central Bank to raise interest rates. "It must be clear to all that an expansive fiscal policy always means a more restrictive monetary policy," says Michael Schubert, a monetary economist at Frankfurt's Commerzbank. "This will make it easier for the ECB to justify a rate hike."

Another issue: French laxness could inspire other nations to loosen the purse strings. Italy, especially, seems set to fall short of its budget pledge, as its economy cools and the government of Prime Minister Silvio Berlusconi makes little headway in cutting spending or injecting flexibility into labor markets. He's even talking about assisting the floundering Fiat auto company--though he stresses that he doesn't want to run afoul of EU guidelines.

The fight with the French also draws attention away from the Germans' own wavering faith in the European idea. Center-left Chancellor Schröder, running hard for reelection in September, has been wasting no time bashing the European Commission and its president, Romano Prodi. When the EC proposed to pry open the cozy links between car dealerships and car manufacturers--a move that could force Germany's Volkswagen to cut prices in its home market--Schröder accused Brussels "Eurocrats" of taking aim at German industry and jobs. "With his Commission-bashing, Schröder is basically saying Germany needs to work out its own industrial policies," says Ulrike Guérot, Europe specialist at Berlin's German Council on Foreign Relations. "But that goes against 20 years of coordinating with the rest of the EU."

The squabbling is set to get even worse. In Brussels, the rolling constitutional convention meant to come up with new and improved institutional reforms is increasingly divided. Germans, for example, are putting their considerable weight behind federalist solutions that mirror their own country's constitutional makeup. France and Britain are backing solutions that emphasize national sovereignty. Some, like Germany and many smaller countries, want to see a stronger Commission and Parliament. Others, like France, favor an intergovernmental approach to decision-making. The convention, chaired by former French President Valéry Giscard d'Estaing, has until the end of 2003 to do its job. The current betting is that the convention will come up with muddled proposals in an effort to paper over divisions.

This stuff sounds abstruse, but it can determine whether Europe ever grows up politically and gets its member states to conform to common economic goals. The disagreements in Brussels are especially disruptive as the EU prepares to bring countries as far afield as Poland and Bulgaria into the union. The infighting also plays into the hands of Europe's far-right politicians, who think Brussels is a menace and who condemn the euro, the Maastricht treaty, and the Stability Pact out of hand.

Some see this as nothing less than make-or-break time for the EU. "The next two years will be remembered as one of those defining moments in the history of Europe. Either it really gels, or you have real problems," says Guérot. "You could have a win-win situation, with a good constitutional convention, a recovering European economy, enlargement to the east, and a receding of right-wing populism," she says. "But the other scenario has Europe being sucked into rising populism, as no one dares to speak about more European integration. That leads to rising interest rates and even more problems on the far right. We end up in 2004 with nothing binding us together but a weak euro." That decidedly unpretty picture is something Europe's fractious leaders ought to reflect on sooner rather than later.

By John Rossant in Paris and David Fairlamb in Frankfurt

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